Wednesday, October 14, 2020

Altman Z-Score: Financial Strength Test in Your MIS

The pandemic has brought many businesses to its knees, which now have an even higher amount of debt, continuing fixed costs, and lower contribution margins owing to sub-par sales figures.

Such times bring about the need for greater discipline in financial management. At this juncture, we recommend businesses to use the following test to track its credit strength and financial performance over the next few months, to ensure that it's on the path to recovery.

Objective of the Altman Z-Score

1. Predicting Bankruptcy: The Z-score is a value derived by running a test of credit strength on a business. The formula is used to predict the probability of an entity going into bankruptcy within two years.

2. MIS Reporting: Companies may use the formula to check their financial health by using simple values as taken from their profit & loss statements and balance sheet, computed as part of its MIS report. The score takes into account profitability, leverage, liquidity, solvency and activity of the enterprise.

3. Investment Decisions: Consider purchasing a stock if its Z-Score value is near 3, and consider selling if the value is closer to 1.8.

4. Economic Analysis: Prof. Altman had calculated that the median Z-score of manufacturing companies in the US in 2007 was 1.81. Such companies had a credit rating of B, mostly. This indicated that 50% of the firms should have had lower ratings, were highly distressed and had a high probability of becoming bankrupt. These calculations led him to believe a crisis would occur due to corporate defaults, which trickled in during 2009.

Calculation Formula

A = Working Capital / Total Assets
B = Retained Earnings / Total Assets
C = Earnings Before Interest & Tax (EBIT) / Total Assets
D = Book (or Market) Value of Equity / Total Liabilities
E = Sales / Total Assets

For Privately Held Manufacturers: Z = 0.72A + 0.84B + 3.107C + 0.42D + 1.0E

For Publicly Traded Manufacturers: Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

For Non Manufacturers: Z = 6.56A + 3.26B + 6.72C + 1.05D

For Emerging Markets: Z = 3.25 + 6.56A + 3.26B + 6.72C + 1.05D

Private Manufacturing Companies:
Score                        Meaning
Below 1.23               Distress Zone - heading towards bankruptcy
1.23 to 2.9                Grey Zone - focus should be on improvement
Above 2.9                Safe Zone - good financial health

Public Manufacturing Companies:
Score                        Meaning
Below 1.8                 Distress Zone - heading towards bankruptcy
1.8 to 3                     Grey Zone - focus should be on improvement
Above 3                    Safe Zone - good financial health

Private Non Manufacturing Companies:
Score                        Meaning
Below 1.1                Distress Zone - heading towards bankruptcy
1.1 to 2.6                 Grey Zone - focus should be on improvement
Above 2.6               Safe Zone - good financial health

Calculation Sheet for Your MIS