Question

What does the Altman Z score tell us with respect to company financial distress? How should we use such a tool as managers? (300 words minimum)

Answer 1

Altman’s Z-score is very useful tool which analyze five key ratios from the financial statement of a company and based on these analyses, it tells the probability of the bankruptcy in any company. These ratios are-

• Working capital / Total assets
• Retained earnings / Total assets
• Earnings before interest and taxes / Total assets
• Market value of equity / Total liabilities
• Sales / Total assets

These ratios are linked to the probability of a company’s bankruptcy or financial distress situation because it is generally found that if the companies have a Z-score above 3 then they are financially sound and if companies have Z-score below 1.8 then they have high probability of bankruptcy or financial distress in near future.

Managers can use these ratios as an important tool to measure the probability of bankruptcy in a company because the aggregate sum of these ratios gives more detail idea of situation which is not possible with the analysis of a single ratio. We can understand the importance of each ratio in following way -

• Working capital / total assets is a good indicator of a firm's ability to make use of what it has in the near future.
• Retained earnings / total assets ratio is an indicator of how in debt the company is and whether it has a history of profitability in the form of retained earnings.
• Earnings before interest and taxes / total assets ratio is a measure of efficiency and it indicates that how the company generates its earnings from each unit of money of assets it has.
• Market value of equity / total liabilities ratio is a measure of the market's confidence in the company’s ability.

Sales / total assets ratio is asset turnover ratio which shows the efficiency of the company to generate the revenue by using its total assets.