Z-Score. A ratio devised by Robert Altman to describe the financial health
of a company, and its likelihood of financial distress. Z-Score works best with
manufacturing companies, but not at all with financials and property companies.
Given:
TA - Total assets
TL - Total liabilities
WC - Working capital (that is, stocks and debtors less short term creditors)
RE - Accumulated retained earnings (the profit and loss account reserve)
EBIT - earnings before interest and tax
S - Sales
MC - Market Capitalisation.
define:
X1 = WC/TA : This measures liquid assets in relation to the firm's size.
Altman, interestingly, mentions that the most widely used current and acid
ratios were not as good predictors as this measure.
X2 = RE/TA : This is a measure of cumulative profitability that reflects
the firm's age as well as earning power. Many studies have shown failure rates
to be closely related to the age of the business.
X3 = EBIT/TA : This is a measure of operating efficiency separated from
any leverage effects. It recognizes operating earnings as a key to long-run
viability.
X4 = MC/TL : This ratio adds a market dimension. Academic studies of stock
markets suggest that security price changes may foreshadow upcoming problems.
X5 = S/TA : This is a standard turnover measure. Unfortunately, it varies
greatly from one industry to another.
For manufacturing companies, Z < 1.8 indicates a bankruptcy candidate,
Z > 3 indicates strong health.
For nonmanufacturing companies, X5 varies significantly by industry.
It is likely to be higher for merchandising and service firms than for manufacturers,
since the former are typically less capital intensive. Consequently, nonmanufacturers
would have significantly higher asset turnover and Z scores. The model is thus
likely to underpredict certain sorts of bankruptcy. To correct for this potential
defect, Altman recommends the following formula: