Who Invented Altman Z score?
The Altman Z-score is calculated using five financial ratios:
- Working capital / total assets
- Retained earnings / total assets
- Earnings before interest and taxes / total assets
- Market value of equity / total liabilities
- Sales / total assets
The Altman Z-score is then classified into one of three categories:
- A score of 3.0 or higher indicates that the company is unlikely to go bankrupt in the next two years.
- A score of 1.8 to 2.9 indicates that the company is in a zone of vulnerability.
- A score of below 1.8 indicates that the company is in a high risk of bankruptcy.
The Altman Z-score is a widely used tool for bankruptcy prediction, but it is important to note that it is not infallible. There are a number of factors that can affect the accuracy of the Altman Z-score, such as the industry in which the company operates and the economic conditions.
Altman Z Score Formula, Interpretation:
The Altman Z-score formula is as follows:
Z = 1.2 * Working Capital / Total Assets + 1.4 * Retained Earnings / Total Assets + 3.3 * Earnings Before Interest and Taxes / Total Assets + 0.6 * Market Value of Equity / Total Liabilities + 1.0 * Sales / Total Assets
The weights assigned to each ratio are based on their predictive power in Altman’s original study. The working capital to total assets ratio measures a company’s liquidity, the retained earnings to total assets ratio measures a company’s solvency, the earnings before interest and taxes to total assets ratio measures a company’s profitability, the market value of equity to total liabilities ratio measures a company’s financial leverage, and the sales to total assets ratio measures a company’s operating efficiency.
How to Avoid Bankruptcy using Altman Z score?
Here are some ways to avoid bankruptcy using the Altman Z-score:
- Monitor your Altman Z-score regularly. The Altman Z-score is a dynamic measure, and it can change over time. By monitoring your Altman Z-score regularly, you can identify early warning signs of financial distress and take corrective action before it’s too late.
- Take steps to improve your liquidity. Liquidity is the ability to convert assets into cash quickly. A company with high liquidity is more likely to be able to meet its financial obligations as they come due. You can improve your liquidity by increasing your cash reserves, reducing your debt, and selling non-essential assets.
- Increase your profitability. Profitability is the ability to generate earnings from your operations. A company with high profitability is more likely to be able to weather financial storms. You can increase your profitability by reducing your costs, increasing your prices, and expanding your market share.
- Reduce your debt. Debt is a liability that must be repaid. A company with high debt is more likely to be unable to repay its debts, which can lead to bankruptcy. You can reduce your debt by paying down your loans, refinancing your debt, or selling assets.
- Maintain a strong equity position. Equity is the difference between a company’s assets and liabilities. A company with a strong equity position is more likely to be able to weather financial storms. You can maintain a strong equity position by retaining earnings and avoiding excessive dividends.
By following these tips, you can improve your chances of avoiding bankruptcy and keeping your company financially healthy.
Here are some of the strengths of the Altman Z-score:
- It is relatively simple to calculate and interpret.
- It has been shown to be effective in predicting bankruptcy in a variety of industries.
- It has been updated over time to reflect changes in the financial markets.
Here are some of the weaknesses of the Altman Z-score:
- It is not always accurate, especially for small companies or companies in emerging markets.
- It does not take into account all of the factors that can affect a company’s financial health.
- It is not a substitute for a thorough financial analysis.
Overall, the Altman Z-score is a useful tool for bankruptcy prediction, but it should be used in conjunction with other financial analysis tools.