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Z-SCORE

Z-SCORE - SOS.BIZ - Giuseppe De Giovanni

The biggest calamity that can befall equity investors is corporate bankruptcy, which wipes out the equity of a firm and knocks the stock’s investment value down to zero.

The Altman Z-Score consists of five performance ratios that are combined into a single score.

 

These five ratios are weighted using the following formula (for not-listed Small Medium Enterprises):

 

Z-Score = 1.5A + 1.44B + 3.64C + 0.7D + 0.64E
 

Where:

A = working capital ÷ total assets;

B = retained earnings ÷ total assets;

C = earnings before interest & taxes ÷ total assets;

D = market value of equity ÷ total liabilities;

E = sales ÷ total assets.

 

When analysing the Z-Score of a company, the lower the value, the higher the odds that the company is headed toward bankruptcy. Altman came up with the following rules for interpreting a firm’s Z-Score:

 

• Below 1.8 indicates a firm is headed for bankruptcy;

• Above 3.0 indicates a firm is unlikely to enter bankruptcy; 

• Between 1.9 and 2.9 is a statistical “gray area”.


deconstructing the z-score

Working Capital to Total Assets

Working capital is a company’s current assets less its current liabilities and measures a company’s efficiency and its short-term financial health. Positive working capital means that the company is able to meet its short-term obligations. Negative working capital means that a company’s current assets cannot meet its short-term liabilities; it could have problems paying back creditors in the short term, ultimately forcing it into bankruptcy. Companies with healthy, positive working capital shouldn’t have problems paying their bills.

 

Retained Earnings to Total Assets

The retained earnings of a company are the percentage of net earnings not paid out as dividends; they are "retained” to be reinvested in the firm or used to pay down debt. Retained earnings are calculated as follows:


"Beginning retained earnings+net income (net loss)–dividends paid"


 The ratio of retained earnings to total assets helps measure the extent to which a company relies on debt, or leverage. The lower the ratio, the more a company is funding assets by borrowing instead of through retained earnings which, again, increases the risk of bankruptcy if the firm cannot meet its debt obligations.

 

Earnings Before Interest & Taxes to Total Assets

This is a variation on return on assets, which is net income divided by total assets. This ratio assesses a firm’s ability to generate profits from its assets before deducting interest and taxes.

 

Market Value of Equity to Total Liabilities

The ratio of market value of equity to total liabilities shows how much a company’s market value (as measured by market capitalization, or share price times shares outstanding) could decline before liabilities exceeded assets.

Unlike the other ratio components used by the Z-Score, market value isn’t based purely on fundamentals - the market capitalization of a firm is an indication of the market’s confidence in a company’s financial position.

Generally speaking, the higher the market capitalization of a company, the higher the likelihood that the firm can survive going forward.

 

Sales to Total Assets

The ratio of sales to total assets, more commonly referred to as asset turnover, measures the amount of sales generated by a company for every dollar’s worth of its assets. In other words, asset turnover is an indication of how efficiently a company is as using its assets to generate sales. The higher the number the better, while low or falling asset turnover can signal a failure by the company to expand its market share.