Monday, March 30, 2009

Assessing company financial health with Altman Z-Score

In early 60's, Dr. Edward Altman (Professor and Vice-Director of New York University's Salomon Center, Leonard N. Stern School of Business) has used Multiple Discriminant Analysis to combine a set of 5 financial ratios and developed the famous Altman's Z-Score.

Nowadays, Altman's Z-Score is being used by many to assess a company's financial health. For instance, investors use it to determine if the company is worth for investment, bankers use it to determine loan risk, etc.

The 5 financial ratios used are:

  • A = Return on Total Assets = EBIT / Total Assets
  • B = Sales to Total Assets = Net Sales / Total Assets
  • C = Equity to Debt = Market Value / Total Liabilities
  • D = Working Capital to Total Assets = Working Capital / Total Assets
  • E = Retained Earnings to Total Assets = Retained Earnings / Total Assets

Different weight factor is applied to the above 5 financial ratios, and the formula to calculate Altman's Z-Score is:

Z = 3.3A + 0.999B + 0.6C + 1.2D + 1.4E

The final result will yield a number between -4 and +8. The higher the score is better.

According to the Altman's Z-Score analysis:

  • When Z is less than 1.8, the company is very likely to have financial trouble
  • When Z is between 1.8 and 2.7, the company's financial situation is fair, and there is risk of getting into financial trouble
  • When Z is between 2.7 and 2.99, the company is not likely to have financial trouble in the near future
  • When Z > 3, the company is financially strong

Note that C which includes the market value of the company, is determined by its share price, and very much influenced by the investment market sentiment. However, C also carries the least weightage, and Return on Total Assets is the most important factor, which I think most fundamentalists are agreeing with.

Over the past 30+ years, Altman's Z-Score was found to be pretty usable to assess company financial health, with accuracy of above 70%.

Altman's Z-Score is a good tool to predict for investment safety, but bear in mind that it is not a tool designed to predict for investment profitability.


forex-tiwisue said... Reply To This Comment

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