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The Altman Z Score: A great tool to identify a company that's in financial strife

by , 04 August 2014

When researching companies to invest in, it can sometimes be difficult to see exactly how a company is doing financially. After all, you don't want to invest in a company with brewing financial issues.

So what's the best way to check out a company's finances? The Altman Z Score is perfect for the task.

Read on to uncover just how you can use the Altman Z Score to weigh up a company before you invest…

The Altman Z Score weighs up the chances of future bankruptcy

In the 1960s, Edward Altman, a professor of finance at New York University, wanted to find a way to work out if a company was heading towards bankruptcy. Through his analysis he came up with a formula that’s good at predicting if a company is facing future financial distress.

This formula is the Altman Z Score, Phil Oakley in Money Week explains. The basis of the formula are five financial ratios. By adding these together you get the Z Score.

Let’s take a look at these five different formulas…

Formula #1: Working capital/total assets
Working capital is the difference between a company’s current assets and current liabilities. (Current means within the year.)

If a company has a small amount or a negative working capital, this is a bad sign.

Formula #2: Retained profits/total assets
Retained profits are the profits a company hasn’t paid to its shareholders.

Weak or young companies tend to have small retained profits. This increases the risk of failure.

Whereas companies with high retained profits tend to finance their business with profits and not debt. Altman takes this as a good sign.

Formula #3: Trading profits/total assets
This measures the productivity of a company. A robust, strong company makes large profits compared to its assets. Weak companies don’t achieve this.

Altman saw this was a good predictor of bankruptcy. He gave it a high weighting in his Z Score calculation.

Formula #4: Market value of equity/total liabilities
This calculates how much a company’s assets can drop in value before they’re worth less than the company’s liabilities. When this happens, a company is insolvent.

For example, a company with equity at R10,000 and debt at R5,000 gives it a market value of R15,000. The company’s assets could drop in value to R10,000 before the company is insolvent.

Formula #5: Sales/total assets
This measures the ability of a company’s assets to generate sales. Essential for any business to survive.

Weighing up the Altman Z Score

Using the Altman Z Score, a score of three or more shows a strong company. When the score is less than 1.8, the company could have issues and financial problems could be on the horizon.

You’ll find that most companies provide the Altman Z Score in its annual accounts.

So there you have it, the Altman Z Score, a great tool to identify a company that’s in financial strife.

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The Altman Z Score: A great tool to identify a company that's in financial strife
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