Before the credit crisis struck in 2008, corporate bankruptcy was the last thing on investors’ minds. It was easy for companies to raise cash at will.

However, over the past three years, times have changed considerably. The number of companies announcing downward revisions to their future growth estimates has increased. Those that are seeing rising pressure on their balance sheets can also be found in plenty.

This means that out-of-favour investment measures, such as Edward Altman’s Z scores (or Altman Z-Score), are being dusted down.

**What’s Altman Z?**

This system was originally devised in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University. He framed this score to warn investors about firms at risk of going bankrupt. Over the years, it has also been used to help investors find the companies that are best able to withstand bankruptcy.

In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years prior to the event.

In subsequent tests over 30 years up until 1999, the model was found to be 80-90% accurate in predicting bankruptcy one year prior to the event.

In 2009, a leading strategy analyst at Morgan Stanley, Graham Secker, used the Altman Z-Score to rank a basket of European companies. He found that the companies with weaker balance sheets underperformed the market more than two thirds of the time.

**How is Altman Z-Score calculated?**

The Altman Z-Score is a quantitative method to determine a company’s financial health, largely by looking at its balance sheet.

“Safe” companies, or the ones that have low probability of bankruptcy, have an Altman Z-Score higher than 3.0. The ones that have high probability of bankruptcy have a score lower than 3.0.

The Altman-Z Score is calculated using five ratios built on key numbers mainly taken from a company’s balance sheet, along with a few from the profit and loss account.

Each ratio is then provided a weight to reflect its relative importance before the five are added together to generate the Altman Z-Score.

Here is the formula:

**Altman Z-Score = 1.2*T1 + 1.4*T2 + 3.3*T3 + 0.6*T4 + 1.0*T5**

Here are the key definitions from the above formula:

**T1 = Working Capital / Total Assets**

This ratio measures liquid assets (which is what working capital denotes). The companies in trouble will usually experience shrinking liquidity.

**T2 = Retained Earnings / Total Assets**

This ratio calculates the overall profitability of the company. Reducing profitability is a warning sign. Also, high levels of retained earnings suggest that a company may have financed its assets through profits rather than borrowings.

**T3 = Earnings before Interest and Taxes / Total Assets**

This ratio shows how productive a company is in generating earnings, relative to its size.

**T4 = Market Capitalization / Total Liabilities**

This ratio suggests how far the company’s assets can decline before it becomes technically insolvent (i.e., its liabilities become higher than its assets).

**T5 = Sales / Total Assets**

This is the asset turnover ratio and is a measure of how effectively the company is using its assets to generate sales.

To reiterate what I mentioned above, the companies that have high probability of bankruptcy have an Altman Z-Score lesser than 3.0. And those that have low probability of bankruptcy have a score of greater than 3.0.

**Altman Z in the Indian context**

As was mentioned above, companies with weaker Altman Z-Scores (or in effect, weaker balance sheets) have underperformed the market more than two thirds of the time in the past. But this is a global statistic.

As such, I did some calculations to see how listed Indian companies with weak Altman Z-Scores (less than 3.0) have performed vis-à-vis companies with good scores (more than 3.0).

Here is a chart that shows the combined stock market returns that the worst 10 Indian stocks on the Z-Score have delivered (over the past 5 years) as compared to the returns delivered by the best 10 stocks.

As you can see from the chart, the safest companies (those with good Altman-Z scores) have massively outperformed the ones that have bad scores. While the 5-year return for the former group stands at a huge 348%, the latter group has actually destroyed capital, with its returns standing at negative -59%.

Data Source: Ace Equity, Safal Niveshak Research

By the way, here are the companies that have the top 10 best and worst Altman Z-Scores.

While much is known about how good or bad these companies are, the Altman Z only validates the point.

**India’s best & worst stocks by Altman Z-Score**

Data Source: Ace Equity, Safal Niveshak Research

**So, is it all gloom and doom?**

The main problem with the Altman Z-Score is that the formula is not suited for many industries. Industries that operate with high borrowings, such as banks & finance companies and power and energy utilities, will always produce a low Altman Z-Score which equates to a high risk of bankruptcy.

This is why it is important for you to not just blindly believe that a low Z score predicts the death of a company. It is just an indicator that suggests the ‘likelihood’ of bankruptcy and not ‘compulsory’ bankruptcy.

You still need to do your homework on the business of the company and its management quality before taking a final call.

So, companies with low scores on Altman Z can also do well, but only when the economy is recovering and thus they get a chance to mend their ways by repairing their balance sheets.

In a weak economic climate like now, it pays to focus a bit on Altman Z.

Good stuff , never heard but now I know 🙂 Colgate is one stock that I have been wanting to buy but never looked deeply into it.

Hi Vikrant,

Thanks for you comment.

Regards,

Vishal

IT IS SO MUCH OF INFORMATION THAT YOU CAN START CHOOSING GOOD COMPANIES WITH THIS PARTICULAR INFORMATIVE PAGE.

vishalji,

please provide for pdf download of this post…..

though know about this concept and used to find out inherent financial strength

you have shown this can be used in different way, for picking good one …

really a good idea.

sri

Hi Sri,

I’ve installed a ‘PDF’ button at the end of the post. You can use this to download the document in a pdf format.

Regards,

Vishal

Hi Sir,

Could you please explain the formula with an expamples( i am new to finance i am learning the investing), please take any one company’s balance sheet and try to show how to takes these values form balance sheet and to calculate.

Regards,

Siva Sankar N.

Hi Siva,

Here are the key constituents of this formula and their respective sources :

1. Working Capital (You will find this in the balance sheet as the “Net Current Assets” figure)

2. Total Assets (Balance Sheet)

3. Retained Earnings (Profit & Loss Account / Balance Sheet)

4. Earnings before Interest and Taxes (Profit & Loss Account)

5. Market Capitalization (BSE’s website)

6. Total Liabilities (Balance Sheet)

You can get these figures readily available in a company’s annual report.

Let me know in case you find it difficult to locate these figures.

Regards,

Vishal

Hi Vishal,

Thanks for the reply, i had found all the values, except one Retained Earnings, could you please help me to find out this value.

And also i have one question – Total Assets and Total Liabilities have the same value wright?

Regards,

Siva Sankar N.

Hi Siva,

You can find “Retained Earnings” in the “Reserves & Surplus” schedule of the Balance Sheet. It’s generally mentioned as “Profit & Loss Account” and represents all accumulated profits that are not distributed to shareholders.

As for your second question, Total Assets and Total Liabilities “don’t” have the same values. You can get Total Liabilities using this formula: TL = Total Assets – Shareholder’s Funds.

I hope this clarifies. Let me know if you face any problem regarding this explanation.

Regards,

Vishal

Thanks a ton for the analysis! a very good and informative post.

Hello. Can you please let me know where I can have access to the full list of indian firms and their Z scores?.

Be careful about the Total Assets. Many Indian balance sheets are in the Source of Fund and Application of Fund format instead of the Total Assets and Total Liabilities format. To get the total assets you have to get the total source of fund and add the current liabilities to it.

Hi Vishal,

Thanks a lot for introducing us to Altman Z score. Although it appears too technical/theoretical, after understanding the components which influence the score, I feel its practically very useful as a Stress Test to see how companies can withstand extreme economic and industry cycles.

Is there any website where I can compare the z scores of Indian stocks? Please advise.

Can I see the historical z scores to check the trend/patter across different periods?

Dear Vishal,

How about an article on application of Beneish M score in the Indian context?

Regards

DEEPAK

Vishal sir, I don’t know your profession but you are a excellent teacher. Please carry on the same.

Thanks Yogesh!

May I know when you would be conducting your next session in Chennai?