In interpretating financial statements, whether financial or non-financial managers normally and frequently use the standard traditional business accounting ratio like profitability, liquidity, market based, assets utilization and others.
However, one ratio commonly neglected is the Z-score model which is actually a quantitative model developed in 1968 by an eminent economist, Edward Atlman. So what is this Altman Z-score model and its purpose?
Atlman Z-score model:
Objective:
Is to predict bankruptcy or financial distress of a business using a blend of the traditional financial ratios and a statistical method known as multiple discriminant analysis(MDA)
Applications of this Z-score model in:
- Loan and credit analysis to determine whether bankers should extend a loan. For a vendor, he or she can determine whether his customer-company is good for payment after being supplied with the goods/materials/services. For a customer to review whether an important supplier is in financial distress.
- Merger analysis-identify potential problem(s) of a merger candidate
- Financial management analysis-to help managers to see wheher the need to curtail capital expansion and dividends pay-out
How to Use the Altman Z-Score Model:
(a) First understand its formula:-
Formula:-Z=1.2*X1 +1.4*X2 + 3.3*X3 + 0.6*X4 +0.999*X5
X1=working capital/total assets
X2=retained earnings/total assets
X3=earnings before interest and taxes (EBIT/total assets)
X5=sales/total assets
(b) Next remember its fundamental guidelines:
Z score Probability of failure
1.8 or less Very high
1.81-2.99 Not sure
3.0 or higher Unlikely
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Simple Illustration Using the Altman Z-score model theory to forecast business failure:
Company XYZ has the following financial details:
Total assets=$2,000
Retained earnings=$750
EBIT=$266
Sales=$3,000
Market value of common and preferred stock=$1,425
Book value of debt=$1,100
Proposed solution:
Computation using the Altman Z-score model formula:
Z=X1=400/2000 *1.2=0.240 + X2=750/2000*1.4=0.525 + X3=266/2,000*3.3=0.439+ X4=1,425/1,100*0.6=0.777 + X5=3,000/2000*0.999 =1.499 =3.480
Conclusion:
Since the score is 3.480 Company XYZ falls into the guidelines/classification of “UNLIKELY” zone which means that there is no change that XYZ will go into bankruptcy within the next two years.
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More salient points on Altman Z-score model:
- Many found this model is quite accurate re:#90% accurate in forecasting business failure on year into the future and about #80% accurate in forecasting it two years into the future
- With the present global credit crunch, it enable the user to predict with reasonable accuracy whether a company is in increasing financial distress so that protective actions like curtailing capital expansion, reducing dividend pay-out or refinancing short term to long term banking structure or facility,etc
- Note that this model can be used for a group of companies.
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