Altman Z score Redux – Covering your back side better

chroma — Sat, 09 Jan 2010 18:12:43 +0000

Altman Z score has been around since the 1960′s and I have posted about it previously. Originally it was set up and measured the risk of bankruptcy among manufacturing firms. It turns out that in subsequent studies it was found that the original Altman Z score might be under reporting bankruptcies among non-manufacturing firms. Given that used correctly it has a 80%-90% accuracy of predicting bankruptcy in the next year, Altman Z is a great tool, but it must be used correctly.

Here is a review of the area’s that Altman tracked:

Altman’s original formula is a weighted sum of different elements, which are as follows.

T1- Working Capital/Total Assets

T2- Retained Earnings/ Total Assets

T3- Earnings before Interest and Taxes (EBIT)/ Total Assets

T4- Market Value of Equity/Book Value of Total Liabilities

T5- Sales/Total Assets

The revised Altman Z score is Z= 6.56T1+3.26T2+6.72T3+1.05T4

You will note that there is no T5 included in this version of the Altman Z score. It seems that including the T5 increased the likelihood of missing a potential bankrupt company for non manufacturing firms. The revised Altman Z score cannot be used for Manufacturing companies, which requires the original Altman Z score. Nor can it be used for privately held, or publicly traded financial companies. Also, beware that companies with one time charge offs may show up negatively. Finally the Z score cannot be accurately used for companies with less than $1 million in assets and reportedly more accuracy may be obtained by using companies with more than $100 million in assets. The Altman Z score is probably not all that accurate in the small camp universe I usually tread. It has more narrowly defined uses than I originally realized.

But as the formula was adjusted for non- manufacturing corporations, so were were the weightings for the individual elements.

Greater than 2.6 is considered safe, financially for the next couple of years.

1.1 – 2.6 Gray Zone. Could go either way.

Below 1.1 Distress Zone. Bad. Likely that the company will bankrupt within two years. Not a lock, but you are warned.

As with any other tool, the Altman Z score has its limitations. But it can be a powerful tool both for avoiding stocks with a high probability of failure and increase the probability of avoiding

Altman Z score – Help Protect your Back Side

chroma — Thu, 24 Dec 2009 20:26:35 +0000

Think of this post as a Christmas present, even though this knowledge has been around for a long time. When you are slumming in the Low Book Value world you need to make sure you are protecting your down side. After all there is a reason most companies have been humbled by the market. The Altman Z-score can be a tool to help you avoid the worse of the companies in the value world.

In 1968 a Professor named Edward Altman devised a formula for predicting bankruptcy. Initially, the Z score was found to be 72% accurate within two years with a 6% false positive rate. In subsequent testing, it was found to be 80-90% accurate within one year with a 15-20% false positive error rate. In other words, if a company fails this test, you are treading way over your head, unless bankruptcy is your desired outcome. In which case you may have found a good shorting opportunity.

For the math avoiders in the group here is a website with an Altman -Z calculator. I don’t use things like this because I am never sure of their accuracy, but it may be better than trying to calculate the Z score on your fingers.

Here is the math that goes with the Altman Z score. Altman’s formula is a weighted sum of different elements, which are as follows.

T1- Working Capital/Total Assets

T2= Retained Earnings/ Total Assets

T3- Earnings before Interest and Taxes (EBIT)/ Total Assets

T4- Market Value of Equity/Book Value of Total Liabilities

T5- Sales/Total Assets

So the actual formula is Z= 1.2T1 + 1.4T2 + 3.3T3 + .6T4 + .999T5.

I always check companies before I invest. I have been scared off more than once by a low Z score. What is good and what is bad?

Greater than 3.0 is considered safe.

1.8-2.99 Gray Zone

Below 1.8 Distress Zone. Bad.

I have added an update to the Altman Z score, which before you use it for investing you should check out at Altman Z Score Redux.

No Related Posts

Chroma Investing » Altman Z score

Altman Z score Redux – Covering your back side better

Related Posts:

Altman Z score – Help Protect your Back Side

Related Posts: