What is the 'Altman Z-Score'

The Altman Z-score is the output of a credit-strength test that gauges a publicly
traded manufacturing company's likelihood of bankruptcy. The Altman Z-score is
based on five financial ratios that can be calculated from data found on a
company's annual 10K report. It uses profitability, leverage, liquidity, solvency
and activity to predict whether a company has a high degree of probability of
being insolvent.

BREAKING DOWN 'Altman Z-Score'

The Altman Z-score is calculated as follows:
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

A = working capital / total assets

B = retained earnings / total assets

C = earnings before interest and tax / total assets

D = market value of equity / total liabilities

E = sales / total assets

NYU Stern Finance Professor Edward Altman, developed the Altman Z-score
formula in 1967, and it was published in 1968. In 2012, he released an updated
version called the Altman Z-score Plus that can be used to evaluate public
and private companies, manufacturing and nonmanufacturing companies, and
U.S. and non-U.S. companies. The Altman Z-score Plus can be used to evaluate
corporate credit risk.

Altman Z-Score Interpretation

A score below 1.8 means the company is probably headed for bankruptcy, while
companies with scores above 3 are not likely to go bankrupt. Investors can use
Altman Z-scores to determine whether they should buy or sell a particular stock if
they're concerned about the underlying company's financial strength. Investors
may consider purchasing a stock if its Altman Z-Score value is closer to 3 and
selling or shorting a stock if the value is closer to 1.8.

Altman Z-Scores and the Financial Crisis

In 2007, the credit ratings of specific asset-related securities had been rated
higher than they should have been. The Altman Z-score indicated that the
companies' risks were increasing significantly and may have been heading for
bankruptcy.

Altman calculated that the median Altman Z-score of companies in 2007 was
1.81. These companies' credit ratings were equivalent to B. This indicated that
50% of the firms should have been rated lower, and they were highly distressed
and had a high probability of becoming bankrupt.

Altman's calculations led him to believe that a crisis would occur and there would
be a meltdown in the credit market. Altman believed the crisis would stem from
corporate defaults, but the meltdown began with mortgage-backed securities
(MBS). However, corporations soon defaulted in 2009 at the second-highest rate
in history