The Altman Z-Score Screen is a useful fundamental tool that can be used by investors to measure the likelihood that a company will go bankrupt. Invented by US finance Professor Edward Altman, the Z-Score analyses five weighted business ratios to estimate the likelihood of financial distress. The five ratios are:
- X1 = Ratio of profit / assets
- X2 = Retained Earnings/Total Assets
- X3 = EBITDA/Total Assets
- X4 = Market Value of Equity/Total Liabilities
- X5 = Net Sales/Total Assets
Without getting too bogged down in why or how the ratios work, so you can simply plug in the values and all the hard work is done, here is an excel spreadsheet calculator – click here
Here is the ratio: Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 +1 X5
|Z Score||Bankruptcy Comment||Flag|
|When Z is >= 3.0||The company is most likely safe based on the financial data.||Safety Zone|
|When Z is 2.7 to 3.0||The company is probably safe from bankruptcy, but this is in the grey area and caution should be taken.||Grey Zone|
|When Z is 1.8 to 2.7||The company is likely to be bankrupt within 2 years.||Grey Zone|
|When Z is <= 1.8||The company is highly likely to be bankrupt.||Distress Zone|
The Z-score is based on 5 ratios i.e. a company’s asset, strength, profitability, solvency and ability to generate earnings. The Z-Score test is not a guarantee but rather an indicator. Back testing over 31 years to 1999 found the Z-Score to be 80% to 90% accurate in predicting bankruptcy one year prior to the event. Based on those odds, it makes sense to have the Z-Score as a final fail-safe check before making an investment.
Note – The Z-Score isn’t recommended for financial institutions due to the regular use of off-balance sheet items and the transparency of their balance sheets. To highlight the importance of the Z-score we have used a recent example of a company that has gone into financial distress.
The case of Virgin Australia Holdings (ASX:VAH)
Virgin Holdings was placed into voluntary administration April this year following the Covid-19 outbreak which saw air travel bans across the globe. As a result airlines were grounded. Roughly 12,000 Virgin Australia creditors, including financiers, employees, unions and bondholders, are owed closed to $7 billion. After failing to secure an agreement on financial support, Virgin Australia was placed in voluntary administration on April 21. Unfortunately, Virgin Australia’s bond holders will be paid first, which means shareholders will receive nothing from the sale of the airline.
Could the Z-Score have prevented an investor from buying shares in the troubled airline?
According to website Gurufocus.com here are the workings to calculate the Z-Score.
Trailing Twelve Months (TTM) ended in Dec. 2019:
- Total Assetswas $4,492 Mil.
- Total Current Assetswas $1,504 Mil.
- Total Current Liabilitieswas $2,248 Mil.
- Retained Earningswas $-1,227 Mil.
- Pre-Tax Incomewas $-205 Mil.
- Interest Expensewas $-131 Mil.
- Revenuewas $4,047 Mil.
- Market Cap(Today) was $4,223 Mil.
- Total Liabilitieswas $4,062 Mil.
Z = 1.2 * X1 + 1.4 * X2 + 3.3 * X3 + 0.6 * X4 + 1.0 * X5
Z = 1.2 * -0.1657 + 1.4 * -0.2731 + 3.3 * -0.0164 + 0.6 * 1.0395 + 1.0 * 0.9009
Z- Score = 0.89
Virgin Australia Holdings has a Z-Score of 0.89 which indicates it is less than 1.8 and in the Distress Zone. VAH was not a stock an investor would want to buy. The theory holds true.
JB Hi-Fi (ASX:JBH) – We decided to try the Z-Score on a company that has a solid balance sheet and is, from what we can tell, doing well during the Coronavirus lockdown. In fact, the company raised its FY20 profit guidance following an uptick in sales since March as the demand for home appliances and electronics sky rocketed because of change in work conditions.
Here are the Z-Score workings:
X1 = 1.2 * (256/992)
X2 = 1.4 * (328/992)
X3 = 3.3 * (543.6/992)
X4 = 0.6 * (5002/551.53)
X5 = 0.99 * (7025/992)
Z-Score = 9.39
Using the Z-Score matrix, companies above 3.1 are well into the stable and healthy zone with a very low probability of financial distress. The company has $292.3 million in debt as of December 2019 which is down from $330.8 million the year prior. Add in its cash and that figures comes down to around $215.5 million. With an EBITDA of 543 million, JBH’s net debt is only 0.39 times its EBITDA – which leaves us pretty relaxed about JB Hi-Fi’s financial position. The Z-Score comes through with the goods once again.