Altman Z-Score

The Altman Z-score is a financial formula developed by Edward Altman in 1968 as a way to predict the likelihood of a company going bankrupt. The formula uses a combination of financial ratios and other variables to generate a single score that indicates a company's financial health.

The formula is based on five financial ratios:

  1. Working Capital/Total Assets
  2. Retained Earnings/Total Assets
  3. Earnings Before Interest and Taxes (EBIT)/Total Assets
  4. Market Value of Equity/Book Value of Total Liabilities
  5. Sales/Total Assets

The formula then assigns weights to each of these ratios, based on their relative importance in predicting bankruptcy, and combines them to generate a single score. The resulting score is interpreted as follows:

  • A score of 3 or higher indicates a company is likely to be financially healthy and not at risk of bankruptcy.
  • A score between 1.8 and 3 suggests that a company is in a "gray zone" and should be closely monitored.
  • A score below 1.8 indicates that a company is at risk of bankruptcy within the next two years.

The Altman Z-score is widely used by investors, creditors, and analysts as a quick and reliable way to evaluate a company's financial health and potential risk of bankruptcy. 

Example:

Let's assume the following financial data for Nvidia:

  • Working Capital = $10 billion
  • Retained Earnings = $15 billion
  • EBIT = $8 billion
  • Market Value of Equity = $150 billion
  • Total Liabilities = $50 billion
  • Sales = $20 billion
  • Total Assets = $100 billion

Using the Altman Z-score formula, we can calculate the following ratios:

  • Working Capital/Total Assets = 0.1
  • Retained Earnings/Total Assets = 0.15
  • EBIT/Total Assets = 0.08
  • Market Value of Equity/Book Value of Total Liabilities = 3
  • Sales/Total Assets = 0.2

Then we can plug these ratios into the Altman Z-score formula, which is:

Z-score = 1.2 * (Working Capital/Total Assets) + 1.4 * (Retained Earnings/Total Assets) + 3.3 * (EBIT/Total Assets) + 0.6 * (Market Value of Equity/Book Value of Total Liabilities) + (Sales/Total Assets)

In this example, the Altman Z-score for Nvidia would be:

Z-score = 1.2 * 0.1 + 1.4 * 0.15 + 3.3 * 0.08 + 0.6 * 3 + 0.2 Z-score = 1.57

A score of 3 or higher indicates a company is likely to be financially healthy and not at risk of bankruptcy. Therefore, Nvidia's Z-score of 1.57 suggests that the company is in the "gray zone" and should be closely monitored. However, it's important to note that the Altman Z-score is just one tool in financial analysis, and other factors such as market trends, competition, and management decisions should also be considered when evaluating a company's financial health.