October 10th 2023

The Altman Z-Score predicts bankruptcy risk using a multi-factor approach. Formulated with key ratios, it gauges liquidity, profitability, solvency, and efficiency. Applicable in bankruptcy prediction and credit analysis, it aids investors and creditors in assessing Financial stability and risk.

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The Altman Z-Score is calculated using the following formula:
[ Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E ]

Where:

A represents Working Capital / Total Assets
B represents Retained Earnings / Total Assets
C represents Earnings Before Interest and Taxes (EBIT) / Total Assets
D represents Market Value of Equity / Total Liabilities
E represents Total Liabilities / Total Assets

Element	Description	Implications	Examples	Applications
Altman Z-Score	The Altman Z-Score is a financial metric developed by Edward I. Altman to assess the likelihood of a company facing financial distress or bankruptcy. It combines multiple financial ratios to provide a comprehensive measure of financial health.	Measures the financial stability and credit risk of a company. Higher Z-Score values indicate lower bankruptcy risk, while lower values suggest a higher risk.	Calculating Altman Z-Score for a company.	Evaluating the financial health and risk of potential investments, making credit decisions, and assessing the likelihood of bankruptcy for companies. It is commonly used in credit analysis and by investors and lenders.
Working Capital	Working capital is the difference between a company’s current assets (e.g., cash, accounts receivable) and current liabilities (e.g., accounts payable, short-term debt). It measures a company’s short-term liquidity.	Positive working capital indicates that a company has more current assets than liabilities, improving its financial stability. Negative working capital may indicate liquidity issues.	Company A has $500,000 in current assets and $400,000 in current liabilities. Working capital = $500,000 – $400,000 = $100,000.	Assessing a company’s ability to cover short-term obligations and maintain operational liquidity, which is crucial for financial stability.
Retained Earnings	Retained earnings represent the accumulated profits and losses that a company has retained over time. It reflects the portion of earnings not distributed to shareholders as dividends.	Growing retained earnings indicate a company’s ability to generate profits and reinvest in its operations. Declining retained earnings may suggest financial difficulties.	Company B has $2 million in retained earnings at the beginning of the year and generates an additional $500,000 in profits during the year. The retained earnings at the end of the year are $2.5 million.	Assessing a company’s profitability and its capacity to reinvest in its business or distribute dividends to shareholders.
Earnings Before Interest and Taxes (EBIT)	EBIT is a measure of a company’s operating profitability. It represents earnings before accounting for interest expenses and taxes.	Higher EBIT indicates stronger profitability, which can contribute to a higher Z-Score. Lower EBIT may raise concerns about a company’s ability to cover debt obligations.	Company C reports EBIT of $1.5 million for the fiscal year.	Evaluating a company’s operating performance and its ability to generate income to meet financial obligations. A higher EBIT contributes positively to the Altman Z-Score.
Market Value of Equity	This represents the market value of a company’s common equity, which is calculated by multiplying the stock price by the number of outstanding shares.	A higher market value of equity reflects a more favorable market perception of the company, which can positively impact the Z-Score. A declining market value may raise concerns.	Company D’s stock price is $50, and it has 1 million outstanding shares. Market value of equity = $50 * 1,000,000 = $50,000,000.	Considering the market’s view of the company’s financial health and stability, as reflected in its equity valuation. A higher market value of equity can improve the Altman Z-Score.
Total Liabilities	Total liabilities encompass all of a company’s debts and financial obligations. It includes both short-term and long-term liabilities.	Higher total liabilities may indicate higher financial risk, potentially lowering the Z-Score. Managing and reducing liabilities can positively affect the Z-Score.	Company E has $3 million in short-term debt and $5 million in long-term debt, totaling $8 million in total liabilities.	Assessing the company’s overall financial leverage and risk associated with its outstanding debts. Lower total liabilities can contribute positively to the Altman Z-Score.

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Characteristics:

Bankruptcy Prediction: Altman Z-Score assesses the likelihood of bankruptcy within a specific time frame.
Multi-Factor Approach: It employs a combination of various financial ratios to comprehensively evaluate a company’s financial health.
Credit Risk Evaluation: Creditors and investors use the Z-Score to determine the creditworthiness of a company before extending loans or investments.

Formula and Interpretation:

Z-Score Formula: Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E, where A, B, C, D, and E are components based on financial ratios.
Interpretation: A higher Z-Score indicates a lower risk of bankruptcy. Specific threshold values are used to classify companies into different risk categories.

Components:

Working Capital/Total Assets (A): Measures the proportion of total assets funded by short-term assets and assesses liquidity.
Retained Earnings/Total Assets (B): Reflects the company’s cumulative profitability and financial stability.
EBIT/Total Assets (C): Evaluates the efficiency of the company’s operations and its return on assets.
Market Value of Equity/Book Value of Total Liabilities (D): Provides insights into the company’s solvency and risk.
Sales/Total Assets (E): Represents the efficiency of asset utilization and turnover.

Applications:

Bankruptcy Prediction: The Z-Score is widely used for predicting the likelihood of financial distress and potential bankruptcy.
Credit Analysis: Creditors employ the Z-Score to assess the credit risk associated with extending loans or credit facilities to a company.

Examples:

Company Analysis: The Altman Z-Score can be applied to evaluate the financial health of a specific company, such as Company X.
Industry Benchmarking: It enables the comparison of Z-Scores among companies within the same industry, providing a relative assessment of financial stability.

Key Highlights – Altman Z-Score:

Bankruptcy Prediction: Altman Z-Score is a robust model for predicting the likelihood of bankruptcy within a specified timeframe, offering crucial insights into financial distress.
Multi-Factor Approach: Leveraging a combination of distinct financial ratios, the Z-Score presents a holistic view of a company’s financial health, enhancing accuracy in assessment.
Credit Risk Assessment: Widely employed by creditors and investors, the Z-Score aids in evaluating the creditworthiness of companies, facilitating informed lending and investment decisions.
Z-Score Formula: Formulated as Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E, where each component captures vital aspects of financial stability.
Interpretation and Thresholds: A higher Z-Score indicates lower bankruptcy risk, and specific thresholds categorize companies into different risk levels, enabling swift evaluation.
Component Significance: Components like Working Capital/Total Assets, Retained Earnings/Total Assets, EBIT/Total Assets, Market Value of Equity/Book Value of Total Liabilities, and Sales/Total Assets reveal liquidity, profitability, efficiency, solvency, and asset utilization.
Applications: Primarily used for bankruptcy prediction and credit analysis, the Z-Score aids in assessing financial resilience and potential default risks.
Industry Utility: Not only valuable for company analysis but also enables industry benchmarking, allowing relative comparisons for better risk assessment and decision-making.

Connected Financial Concepts

Circle of Competence

The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.

Micro-Investing

Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

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