For investors looking to limit downside risk, the Altman Z Score can be an excellent formula for determining the true strength of a company.
What makes this risk management tool so great is that it focuses almost exclusively on the financials of the business, rather than how Wall Street perceives it through price action. This is in contrast to other risk management tools such as trailing stops or momentum indicators, which could be based more on emotion rather than business financial reality.
In this post, I’ll go over both the positives and the limitations of the Altman Z Score by breaking it down into each of its 5 formula categories. I’ll also show you how to calculate the Altman Z score exactly by using a real life balance sheet and 10-k as an example.
Has the Altman Z Score Formula been successful in calculating risk in the past?
This formula was published in 1968, and so we have a long period of time to evaluate its track record through various bull and bear markets.
Perhaps its strongest piece of supporting evidence was the fact that right before the financial crisis of 2008 the median Altman Z score formula across the stock market was 1.81. As we now know, the following years were troubling for many companies.
Various financial websites and blogs have posted that the Altman Z score formula has had an accuracy rate as high as 90% for bankrupted companies.
In an interesting report draft that was published online about the Altman z score’s results in the UK from around 1979 to 2003—using a modified UK version z score that was published around the beginning of that time period (1977) by Agarwal and Taffler.
In this UK version, a z score below 0 was indicative of high risk, while one above 0 was generally considered a signal of strength. Interestingly, one of the tables in the report draft reported a total failure rate for z<0 at 3.2, while the failure rate for z>0 was 0.1.
This seems to prove there’s strong evidence for the validity of the Altman Z Score formula due to its track record across time periods and even countries.
But, we know that no single metric is perfect, and we must examine the possible limitations for the Altman z score formula in any of its 5 formula categories.
How to Calculate the Altman Z Score
The Altman Z Score formula is 5 ways—I’ve denoted each with a “z” before the number. Each formula category can be examined with the following financial statements:
- “z1”: Balance Sheet – Working Capital and Total Assets
- “z2”: Balance Sheet – Retained Earnings and Total Assets
- “z3”: Income Statement and Balance Sheet – EBIT and Total Assets
- “z4”: Stock Market Data and Balance Sheet – Market Capitalization and Total Liabilities
- “z5”: Income Statement and Balance Sheet – Net Sales and Total Assets
As you can see, there’s a heavy focus on the balance sheet of a company when it comes to determining its long term financial strength.
This makes a lot of sense, since earnings (income statement) are much more volatile than the assets on the balance sheet from year to year, and earnings are derived out of assets. Expenses on the income statement can easily be cut to boost profits or maintain profitability during a down year, while debt and other related long term liabilities on the balance sheet aren’t as easily cut and must be paid off somehow.
The way that the Altman Z Score formula works is on a number scale. Each category is added together to come up with the final total.
The lower a company scores, in general, the more at risk for bankruptcy it likely is.
Edward Altman defined 1.8 and below as being extremely risky (in the same level as a Moody’s B credit score), the range between 1.8 – 3 to be a sign that caution should be applied, and that any z score above 3 was a signal of great financial strength.
The exact formula is the following:
Altman Z Score = (1.2 * z1) + (1.4 * z2) + (3.3 * z3) + (0.6 * z4) + z5
Let’s calculate each of these 5 formula categories with an example, talk about how each are useful, and discuss any limitations with them.
z1 = Working Capital / Total Assets
How to Find Total Assets in the Balance Sheet
Total Assets are a required line item for every company’s consolidated balance sheet inside the 10-k. Every asset is automatically added up and placed in this line item, which usually falls around the middle of the balance sheet.
Here’s an example using the 2019 10-k from Nielson Holdings (NLSN)…
Keep this figure in mind as I’m showing you how to calculate the Altman Z score, because it will be used in 4 out of the 5 formula categories.
How to Calculate Working Capital from the Balance Sheet
Working Capital is calculated by taking Current Assets and subtracting Current Liabilities. These metrics are typically found at the top of the consolidated balance sheet.
Current assets can include things like cash, inventory, and account receivables, which are basically invoices payable to the company. Current liabilities include things like accounts payable, which are payments due to suppliers, and income tax expenses that will be due soon.
Working Capital = Current Assets – Current Liabilities
Taking our NLSN example to calculate z1, we see Current Assets = $2,003, Current Liabilities = $1,657, and Total Assets= $15,179.
The working capital for NLSN is then $2,003 – $1,657 = $346.
The z1 score for NLSN is Working Capital / Total Assets = ($346) / ($15,179) = 0.022.
Altman Z Score Limitations for z1
Working capital can tell investors about the relationship between how a company collects sales and how it pays suppliers.
You could argue that for a company that collects payment upfront, a negative working capital isn’t actually a flaw but rather a feature for running the business. Depending on the timing of it, a negative working capital could be making the numbers look worse than reality. For companies where this could be the case, the Altman Z score would likely be a poor representation of actual risk.
However, a company that’s struggling to make profits or sales on their inventory could also have negative working capital, in which case this calculation for the Altman Z score isn’t a limitation but rather accurate.
z2 = Retained Earnings / Total Assets
How to Calculate Retained Earnings from the Balance Sheet
We can easily find retained earnings by looking near the bottom of a company’s balance sheet next to Shareholder’s Equity.
Here’s where that’s located for NLSN:
To calculate z2, simply plug in the numbers we’ve found already. For NLSN, Retained Earnings = -$795 and Total Assets = $15,179.
Therefore, NLSN’s z2 score = Retained Earnings / Total Assets = (-$795) / ($15,179) = -0.05.
You can see that this returns a negative value and will greatly reduce the overall score—indicating a more risky situation. This is what we should expect for a company with a retained earnings deficit.
Altman Z Score Limitations for z2
When a company creates earnings, they have several options for what to do with it. They could give some of it back to shareholders in a dividend, they could buyback shares, they could pay off debt, or they could reinvest the earnings back into the business,
Reinvesting earnings back to the business is an obvious way to grow, and it goes back to what we discussed earlier. By using retained earnings to later buy more income producing assets, higher future profitability it possible.
A company with little retained earnings compared to their total assets is then less likely to grow their business in the future.
The limitations for this part of the Altman z score formula is that there can be two different reasons why a company is able to grow the business without retained earnings.
Growing earnings without using retained earnings needs either debt to be taken out to fuel the growth (obviously bad), or the company could be simply becoming more efficient (good).
This formula category has a limitation here because a company could be punished for choosing to allocate capital back to shareholders rather than reinvest in suboptimal conditions. This becomes a false flag especially if it’s just a temporary development.
z3 = EBIT / Total Assets
How to Calculate EBIT from the Income Statement
The acronym EBIT stands for Earnings Before Interest and Taxes. This is a metric that falls in between the top line (revenue) and bottom line (net income/ earnings).
Another way that EBIT is commonly described on the income statement is “operating income”.
Basically you take the revenue and subtract the operating expenses (or cost to sell goods) and you get the calculation for EBIT.
Here’s the income statement for NLSN and the relevant EBIT figure:
To use this to calculate the z3 for NLSN = EBIT / Total Assets = (-$475) / ($15,179) = -0.03.
Altman Z Score Limitations for z3
Similar to the retained earnings limitation we described above, the limitations behind examining EBIT rather than Net Income come from the fact that the core operating section of a business doesn’t tell the entire picture behind the business.
A business could have a fantastic business model but be run by incompetent management who are poor capital allocators, and frivolously spend money on poor investments or run up a lot of debt.
The income statement and earnings picture only tell one half of the story behind a company’s finances, and this fact coupled with the narrow examination of retained earnings can magnify this effect in certain cases.
z4 = Market Value of Equity / Total Liabilities
How to Find Total Liabilities in the Balance Sheet
There are two ways to find Total Liabilities in the Balance Sheet. One way is just to look below the Total Assets where each liability line item can be found, and then find the line item for Total Liabilities.
However, some companies don’t display the Total Liabilities line item in their consolidated balance sheet. In this case, you’ll have to calculate it.
Instead of adding up each liability to calculate Total Liabilities, I suggest taking Total Assets and subtracting Shareholder’s Equity. It’s a much simpler calculation and serves the exact same function.
For NLSN, Total Liabilities is calculated for us:
How to Calculate Market Value of Equity
This is another way of saying Market Capitalization, and can be found by inputting the ticker into most financial websites. The formula for Market Capitalization is Share Price multiplied by Shares Outstanding.
I took a screenshot from the Google Finance chart for NLSN to find the company’s market value of equity:
With these two metrics, we can calculate NLSN’s z4 = (Market Value of Equity) / (Total Liabilities) = ($9.43 billion) / ($12,136 million or $12.136 billion) = 0.78.
Altman Z Score Limitations for z4
This formula category’s limitation is one of the easiest to spot, and it’s also one of the most attacked parts of the Altman Z Score. In this case, the higher a stock’s price the higher the formula scores.
As we should know, a stock price has little to no bearing on a company’s financial condition. The stock market has been known to be irrational, and unsuspecting investors are caught up all the time in stocks they should’ve never been in—because the financials were awful.
Yet there’ll always be investors who try to catch a falling knife, and there’ll always be investors who aren’t as risk averse to a business’s financial troubles.
z5 = Net Sales / Total Assets
How to Calculate Net Sales in the Income Statement
This is a metric that falls on the top of the income statement, and sometimes is calculated as Net Sales as the very first line item (as sales, net sales, revenue, or net revenue) or just below it after expenses or cost of goods (also usually expressed as net sales or net revenue, or total sales or total revenue).
Note that this is different than the EBIT or operating income number, and doesn’t include expenses such as administration costs and advertising expenses.
Depending on the 10-k you might have to calculate net sales yourself if there’s no line item for it. With our NLSN example, that’s what we’ll have to do.
Looking at the top of the income statement, we can calculate Net Sales by taking “Revenues” and subtracting “Cost of Revenues” = ($6,515) – ($2,805) = $3,710.
With this metric we can calculate z5 = Net Sales / Total Assets = ($3,710) / ($15,179) = 0.24.
Altman Z Score Limitations for z5
This formula category could unfairly punish businesses with high profit margins. A business with a high profit margin needs less sales to make the same earnings as other profitable companies.
You can argue that profit margins tend to suffer from reversion to the mean and that in general more sales are better, but it can still paint a certain business as in a worse case than it actually is—especially in an extreme case.
The Final Calculation for our Altman Z Score formula Example
Putting all of the formula categories above together, we can calculate the Altman Z Score for our example stock NLSN.
Altman Z Score = (1.2 * z1) + (1.4 * z2) + (3.3 * z3) + (0.6 * z4) + z5 = (1.2 * 0.022) + (1.4 * (-0.05)) + (3.3 * (-0.03)) + (0.6 * 0.78) + 0.24 =
0.026 – 0.07 – 0.099 + 0.468 + 0.24 = 0.565.
As you can see, the Altman Z Score for NLSN is 0.565, which indicates a company that’s in pretty bad shape financially.
While a formula like the Altman Z Score isn’t a one stop shop for determining when to buy and sell a stock, it can be a useful tool to at the very least help an investor be aware of a company in dire financial straits.
Combining this formula with other risk management tools (such as the Value Trap Indicator) can be a way to separate the outliers (and possible exceptions to the rule) from the businesses that are clearly in trouble—and the stocks to clearly avoid.