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:
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.
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.