In early 60's, Dr. Edward Altman (Professor and Vice-Director of New York University's Salomon Center, Leonard N. Stern School of Business) has used Multiple Discriminant Analysis to combine a set of 5 financial ratios and developed the famous Altman's Z-Score.
Nowadays, Altman's Z-Score is being used by many to assess a company's financial health. For instance, investors use it to determine if the company is worth for investment, bankers use it to determine loan risk, etc.
The 5 financial ratios used are:
- A = Return on Total Assets = EBIT / Total Assets
- B = Sales to Total Assets = Net Sales / Total Assets
- C = Equity to Debt = Market Value / Total Liabilities
- D = Working Capital to Total Assets = Working Capital / Total Assets
- E = Retained Earnings to Total Assets = Retained Earnings / Total Assets
Different weight factor is applied to the above 5 financial ratios, and the formula to calculate Altman's Z-Score is:
Z = 3.3A + 0.999B + 0.6C + 1.2D + 1.4E
The final result will yield a number between -4 and +8. The higher the score is better.
According to the Altman's Z-Score analysis:
- When Z is less than 1.8, the company is very likely to have financial trouble
- When Z is between 1.8 and 2.7, the company's financial situation is fair, and there is risk of getting into financial trouble
- When Z is between 2.7 and 2.99, the company is not likely to have financial trouble in the near future
- When Z > 3, the company is financially strong
Note that C which includes the market value of the company, is determined by its share price, and very much influenced by the investment market sentiment. However, C also carries the least weightage, and Return on Total Assets is the most important factor, which I think most fundamentalists are agreeing with.
Over the past 30+ years, Altman's Z-Score was found to be pretty usable to assess company financial health, with accuracy of above 70%.
Altman's Z-Score is a good tool to predict for investment safety, but bear in mind that it is not a tool designed to predict for investment profitability.