One of the greatest fears for any shareholder is seeing their company go bankrupt. Regardless of the type of bankruptcy (chapter 7 or 11), everyone else (creditors etc.) gets paid first before the stockholder. Consequently, bankruptcy is a concern, especially for investors with portfolios heavily weighted towards small caps and growth companies. So what if you could predict the probability of a company going bankrupt? Edward I. Altman, a Professor of Finance at the NYU Stern School of Business, created a metric to do just that. The Altman Z score is metric used to find financially sound companies that have a low probability of becoming insolvent in the near future.
We have the Altman Z score in Stock Rover as a Premium metric. In this post, I’ll go into detail about how this popular metric is calculated, including some detail about what metrics go into it, and how you can find its trend over time to get an even better sense of a company’s financial footing.
Professor Altman developed the Z score model in 1968 (revised paper, 2000) . The Altman Z score is a linear regression of five weighted financial metrics—ranging from operating ratios to valuation metrics (described in detail below)—used to determine the probability of bankruptcy. The weights were determined from a sample of 66 companies grouped into two 33 member groups. Group one consisted of manufacturers who had filed for bankruptcy while the second group comprised non-distressed firms.
To get the final Z score, the weights are multiplied by the ratios and the products are summed up. The regression is shown below:
Z=1.2×[(Working Capital)/(Total Assets)]+1.4×[(Retained Earnings)/(Total Assets)]+3.3×[EBIT/(Total Assets)]+0.6×[(Market Cap)/(Total Liabilities)]+0.99×[Sales/(Total Assets)]
A Z score below 1.8 indicates that a firm is headed for bankruptcy, a score between 1.8 and 3 signals a statistical gray area, and a score above 3 indicates that company is unlikely to go bankrupt.
Let us deconstruct the various metrics used in the Z score:
This ratio divides Working Capital (the difference between current assets and current liabilities) by Total Assets (sum of total current assets and fixed assets or total liabilities plus net worth). It is a measure of a firm’s liquidity or short term health. A firm that has operating losses will have declining current assets and consequently a falling Working Capital/Total Assets ratio. Additionally, a firm experiencing liquidity problems will have a falling WC/TA ratio.
This ratio captures the capital structure of a company by dividing Retained Earnings (the portion of net income not paid out as dividends but kept for reinvestment into the business) with Total Assets. The lower the RE/TA ratio the more the company funds its assets by borrowing as opposed to retained earnings which increases it chances of bankruptcy. The ratio is also a proxy for a firm’s age, i.e. older companies will have more Retained Earnings than younger companies. Thus, this metric gives the Altman Z score a bias toward older companies, which may be appropriate, as younger companies have a higher chance of bankruptcy than older ones.
This ratio is a measure of the “true productivity of the firm’s assets, independent of any tax or leverage factors (Altman 2000).” A lower ratio indicates a company has declining earning power (lower EBIT) and insolvency occurs when total liabilities begin eroding that earning power (Total Liabilities are part of Total Assets because TA equal Total Liabilities plus Net Worth). Since EBIT is also known as Operating Income, the ratio can also be written as Operating Income/Total Assets.
The market value of equity is the market capitalization thus the ratio can be rewritten as Market Capitalization/Total Liabilities (MC/TL). A ratio above one is good as that entails that Total Liabilities have not exceeded the market value of the firm but the higher the ratio the better financial condition of the company. Unlike the other Z score metrics, this ratio is not a pure fundamental ratio because it incorporates market cap which has a stock price and stock price is not always a reflection of the true fundamental value of a firm.
This ratio is an efficiency metric used to gauge how good a company is at using assets to generate sales. It is also known as Asset Turnover. The higher the number the more efficient a company is at generating sales. If a company is taking on more debt (TL is rising thus TA is rising because TA = TL + Net Worth), it better be efficient at using those assets to generate sales because inefficiency in generating sales can quickly lead to bankruptcy as there will be less revenue to pay back the debt.
As I mentioned in the opening, Stock Rover actually calculates the Altman Z Score for you, but before we take that shortcut, let’s work it out on our own. To calculate a company’s Z score, you will need its market capitalization, sales and operating income figures from the income statement, and current assets, current liabilities, total liabilities, retained earnings and total assets data from the balance sheet. Since the Altman Z score seeks to determine the financial health of a firm, it takes most of its data from the balance sheet.
As an example on how to calculate the Altman Z score, I will use Incyte (INCY)—the biopharmaceutical focused on developing oncology drugs. I chose a biopharmaceutical because normally these companies do not make any profits for their first few years of operation, they incur huge deficits and the likelihood of pipeline success is always a long shot. Consequently, the chances of a young pharmaceutical going bankrupt are usually very high. I specifically chose Incyte because it qualified as a potential candidate for a Gilead(GILD) acquisition in my recent article because of its strong oncology pipeline.
Collecting the aforementioned data on Incyte from the balance and income statement, we have:
These are all the values we need to calculate the Z score. Now, we need to calculate the five ratios of the equation (remember, working capital is just current assets less current liabilities, and EBIT is the same as operating income):
When we have calculated the different ratios, we multiply them by the weights (coefficients) that Altman ingeniously identified:
Finally, we need to these products up, and the sum will be our Altman Z score:
As discussed earlier, a score below 1.8 means a firm is headed for bankruptcy, between 1.8 and 3 is a statistical grey area and needs further research, and above 3 means it is unlikely to become insolvent. Incyte’s 13.7 score is far greater than 3 therefore it is in sound financial health and is unlikely to go bankrupt.
Even though a single Z score is telling about Incyte’s current financial wellbeing, understanding the Z score trend over time gives even better insight into the financial health of a company. With historical Z scores, we can see whether overtime Incyte’s financial condition has been improving or deteriorating.
We have historical Z scores in Stock Rover, making this task extremely easy, but, for practice, let’s run the process manually. To do this, we need to go back to Incyte’s income statements and balance sheets and collect historical sales, EBIT, market cap, current assets, current liabilities, retained earnings and total assets data. In this instance, I only went back five years.
Now, the ratios for each individual year:
Next, multiply the ratios with the coefficients:
Then lastly, sum the results and you will get the Altman Z scores for Incyte for each of the last five years:
To better see the trend of Incyte’s Altman Z score, I charted the results:
This is a better picture of Incyte’s financial health than a single z score. It is clear that overtime, Incyte has improved it financial condition. Overall, Incyte is in good financial health and it is unlikely that the pharmaceutical will go bankrupt in the near future.
As enjoyable as it was to calculate the Altman Z score from scratch, it becomes tedious if we went back ten years and calculate a score a Z score for every year, and especially if we have to do it for multiple companies. So now I am going to show you how to do this in Stock Rover if you have a Premium account (you can alsoactivate a Premium trial if you are a Basic user and want to test this out).
Going back ten years to 2005, here are Incyte’s Z scores:
You can get this information in the Table by first adding the Altman Z score column (here’s how to add a column) and then expanding the row by clicking the little arrow button next to the ticker name (see here). Charting Incyte’s ten historical Z scores:
As you can see above, Incyte had the highest probability of going bankrupt during 2008 when it had the lowest Z score (-8.1). Incyte’s financial health was at its worst then but that has since changed. The company has moved into positive Z score territory because overtime it has reduced net losses and may soon breakeven.
The bottom line: because of the Incyte’s high Altman Z score and, more importantly, its rising Altman Z score, we can conclude that it is unlikely that the firm will go bankrupt in the medium-term future. Does that mean it is a good investment? Not necessarily, but it’s a good start.
Now you know where the Altman Z score comes from and you know how and why to use it. In my next post, I will construct a screener specifically to find stocks with an increasing Altman Z score, to see how they perform. Stay tuned!
Did you do the stock screener for the Z test ?
Not in this article – here we just looked at the historical Z scores for one company (in the Stock Rover table – we added the Altman Z column; here are instructions for adding a column: https://www.stockrover.com/how-to/the-table/change-columns/).
We do discuss an Altman Z score screener in the follow-up article to this one: https://www.stockrover.com/blog/stock-research/altman-z-score-screener/
You can also add the Altman Z score as a criteria to any screener if you are a Premium user.
Hope this helps!
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