Evaluating a company’s financial health and performance always involves a degree of uncertainty, but there are measures that can be utilized to more objectively review financial strength.
Metrics, such as the Altman Z-Score, have been developed in an attempt to provide more insight into complex financial statements so that notable events, like financial distress and bankruptcies, could be predicted in advance.
The Altman Z-Score is a mathematical formula that was designed to predict bankruptcy or insolvency. It was originally developed and published in 1968 by New York University professor Edward Altman – and since that time, the Altman Z-Score has become a widely-used and trusted measure of financial distress. The formula takes into consideration essential measures of performance and creates a robust tool for evaluating a company’s health and performance.
In Altman’s original paper, the Z-Score proved to be 72% accurate in predicting bankruptcy within the prior two years, and in subsequent tests, Altman found the Z-Score to be between 80% and 90% accurate in predicting bankruptcies.
Further research applying the Z-Score formula to financial statements has indicated that companies with weak Z-Scores were found to underperform the market by about 5-6% per year over the course of almost two decades.
In order to determine a Z-Score, different formulas can be applied to manufacturing-type and non-manufacturing companies.
Once the calculation is completed, the scores fall into zones, classified as the Safe Zone, the Grey Zone, and the Distress Zone.
A Z-Score that falls in the Distress Zone is an indicator of financial distress. However, it is equally important to take note of scores that fall in the Grey Zone and that decrease year over year, as decreasing Z-Scores are also an indicator of deteriorating financial health.
For the average user of financial statements, it may be difficult to complete the complex calculations involved in determining a Z-Score. To make this useful metric more accessible, Audit Analytics calculates these scores automatically, directly from a company’s financial statements, and flags notable Z-Scores in our Accounting Quality + Risk Matrix (AQRM).
For Audit Analytics, a notable Z-Score includes:
- If the company’s Z-score falls below the threshold for the Distress Zone
- If the company’s Z-score decreases two consecutive years and falls in the Grey Zone
Between 2014 and 2019, around 84% of companies that have filed for bankruptcy have been observed as having a notable Altman Z-Score within the three years prior to the bankruptcy filing.
While there are fluctuations over the six year period in the percent of bankrupt companies that had a notable Altman Z-Score in the previous three years, it is consistently above 70%, illustrating a strong relationship between notable Z-Scores, as represented in the Audit Analytics AQRM, and subsequent bankruptcies.
It is important to note that there are significantly more companies with notable Z-Scores that do not go bankrupt, compared to those that do, highlighting that the Z-Score is a red flag for potential financial distress and can assist with identifying companies that may require additional scrutiny – but the metric cannot absolutely predict bankruptcy.
As an example of the usefulness of Z-Scores, consider the recent well-known collapse of Toys “R” Us, Inc., which filed for Chapter 11 bankruptcy in 2018. The bankruptcy didn’t come as a surprise to those closely following the industry due to a variety of factors, but it also should have come as no surprise to those looking at Altman Z-Scores for the Company. Between 2012 and 2017, the calculated Z-Scores for Toys R Us failed to climb out of the Distress Zone, except in 2013 when the Z-Score fell in the Grey Zone. Similarly, Sears Holdings Corp filed for bankruptcy in 2018 after five consecutive years of decreasing Altman Z-Scores, all in the Distress Zone.
To illustrate the importance of decreasing Z-Scores in consecutive years, consider the example of Tempur Sealy International Inc. The Z-Score calculated from the annual financial statements in 2016 was in the Safe Zone, but the Z-Score for fiscal year 2017 decreased into the Grey Zone, and fell even further into the Grey Zone in 2018. The mattress manufacturer subsequently filed for Chapter 11 bankruptcy in 2019.
There is no guarantee when making predictions regarding financial distress, and the Altman Z-Score cannot be used as an absolute predictor of imminent bankruptcy or insolvency. However, Z-Scores are a powerful metric to provide an unbiased assessment of a company’s financial health.
This analysis was performed using data obtained from the Audit Analytics Accounting Quality Risk and Bankruptcies databases.
To learn more about how Audit Analytics can help identify red flags for companies in your portfolio, or for current/potential clients, please contact us.