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Understanding Altman Z-Score of companies
Hello and welcome to a new lesson today.
In today's class, we shall discuss about the solvency of a company.
First, let us see the definition for the term Solvency'
Solvency tells us the ability of a company to pay its debts.
In particular, we are interested in knowing if the company is in possession of assets in excess of its liabilities.
Now, let us see the new rule we are building today:
Rule #32: Understand solvency of the company when investing in it. Prefer companies with Altman Z-Score above 2.6
Altman Z-score is a globally renowned method used to measure the solvency of a company.
It was developed by Edward Altman and hence the name Altman Z-score.
It uses a computation / algorithm that has been found to have useful predictive value on the likelihood of a business going bankrupt.
This is just a likelihood computation and not a prediction.
This is because, even though the financial figures of a company make us feel that the company is on the edge of bankruptcy, there are several situations where the managements of the companies steer the company and bring it from the blink of sinking.
How accurate is the Altman Z-score?
Altman tests showed that there is a possibility of 72 per cent accuracy in predicting bankruptcy two years before the event and as much as 80-90 per cent accurate one year before the event.
So, the computation is really a useful measure for us.
Z > 2.6 are considered in 'Safe' Zone
1.1 < Z < 2.6 are considered in 'Grey' Zone
Z < 1.1 are considered in the 'Distress' Zone
How to compute Altman Z-score?
As I said, the computation of Altman Z-score is based on an algorithm.
Instead of computing outselves, it is better to use websites such as ValueResearchOnline that provide the score.
This feature is available for (free) logged-in users.
For instance, the Altman Z-Score for Karturi Global Limited is at https://www.valueresearchonline.com/stocks/snapshot.asp?code=6277&colzscr=1
Its Altman Z-Score is 0.89.
This means, the company is in 'Distress' Zone which is not a good thing.
Now, let us check the score for Coal India.
The score is 3.16 and is available at https://www.valueresearchonline.com/stocks/snapshot.asp?code=4673&utm_source=direct-click&utm_medium=stocks&utm_term=Coal+India&utm_content=Coal+India&utm_campaign=vro-search
A score of 3.16 is 'Safe' Zone.
Limitations of the method
This scoring method cannot be appied on Banking and Financial Services companies.
- For the list of companies that you are invested, check the Altman score of each of your company.
- Identify why Altman Z-Score cannot be computed for Banking and Financial Services companies.
- Debt-free / Low-debt / Virtually-debt free companies (Rule 10)
- Introduction to Financial Ratios used in Stock Analysis
- Generating a stock investment idea
- Stock Financial Trend Analysis