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Credit Analysis: Altman Z-Score

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Altman Z-Score: Predicting Financial Distress and Bankruptcy

Understanding the Altman Z-Score

The Altman Z-Score is a special formula that helps us know if a company might go broke or not. It looks at many different money numbers and gives us one important score. If the score is too low, it means the company might have a problem and could go bankrupt.

Components of the Altman Z-Score

The Altman Z-Score uses five different money numbers to calculate the score. These numbers tell us different things about a company's money situation. Here's how they are calculated:

  • X1: We subtract the money the company owes from the money it owns right now. Then we divide that number by all the money the company has.
  • X2: We look at how much money the company has kept for itself and divide it by all the money the company has.
  • X3: We look at how much money the company made from selling things and divide it by all the money the company has.
  • X4: We look at how much people think the company is worth on the stock market and divide it by how much the company owes.
  • X5: We look at how much money the company made from selling things and divide it by all the money the company has.

Interpretation of the Altman Z-Score

The Altman Z-Score gives us one important number to understand if a company might have money troubles. If the number is less than a certain amount (like 1.81 for some kinds of companies), it means the company could have problems and might go bankrupt. The lower the number, the more likely it is for the company to have money troubles.

Significance of the Altman Z-Score

The Altman Z-Score is a special tool that helps us see if a company is stable and might go bankrupt. By looking at the Z-Score, we can understand how healthy a company's money situation is. It's like a warning system that helps people like investors, creditors, and analysts know if a company is risky or not. This helps them make smart choices about things like investing money, giving loans, or doing business with the company.

Example

Let's pretend there's a company called XYZ, and it has the following money information:

  • Current Assets: $500,000
  • Current Liabilities: $300,000
  • Retained Earnings: $200,000
  • Total Assets: $1,000,000
  • EBIT: $150,000
  • Market Value of Stock: $400,000
  • Book Value of Liabilities: $350,000
  • Sales: $800,000

We can use these numbers to calculate the Altman Z-Score for Company XYZ:

  • X1 = ($500,000 - $300,000) / $1,000,000 = 0.2
  • X2 = $200,000 / $1,000,000 = 0.2
  • X3 = $150,000 / $1,000,000 = 0.15
  • X4 = $400,000 / $350,000 = 1.14
  • X5 = $800,000 / $1,000,000 = 0.8

Now, we can put these numbers into the formula and find the Altman Z-Score for Company XYZ:

  • Z = 1.2(0.2) + 1.4(0.2) + 3.3(0.15) + 0.6(1.14) + 1.0(0.8) = 1.536

In this example, Company XYZ has an Altman Z-Score of 1.536. Since the Z-Score is lower than the threshold of 1.81 for some companies, it means Company XYZ might have money troubles and could go bankrupt.

Conclusion

The Altman Z-Score is a special model that helps us predict if a company might have money troubles and go bankrupt. By using different money numbers, the Z-Score gives us one important score to understand if a company is risky or not. If the Z-Score is lower than a certain amount, it means the company could have money problems. By looking at the Altman Z-Score, people like investors, creditors, and analysts can know if a company is financially healthy or risky. This helps them make good choices about things like investing money, giving loans, or doing business with the company.

This article takes inspiration from a lesson found in FIN 689 at Pace University.