Monday, July 19, 2010

Find Tenant's Altman Z-score to determine solvency

A recent article from American Express Open Network gives us a guideline for determining the solvency of companies that may even be our tenants in commercial properties. The article uses NYU Prof. Max Heine's updated research of the Altman Z-Score by Edward Altman. Brief Recap:

The Altman Z-score for Predicting Bankruptcy

The Z-score formula developed in 1968 by Edward Altman determines the probability that a company will go bankrupt within two years.  It remains the most-used and most-respected method for predicting bankruptcy.  The formula was originally designed for public manufacturing companies with at least $1 million in assets but versions for non-manufacturing and private companies have been developed.  Multiple tests have been conducted in the 40 years since the formula was developed to determine its efficacy.
Recent follow up tests show that the formula is 80 percent to 90 percent accurate at predicting bankruptcy within one year.

Ingredients for an Altman Z-score

The Z-score is basically a mathematical formula that takes the weighted sum of five key business ratios.  The five ratios that are used to calculate the Altman Z-score are:

  • T1 = Working Capital / Total Assets
  • T2 = Retained Earnings / Total Assets
  • T3 = Earnings Before Interest and Taxes / Total Assets
  • T4 = Market Value of Equity / Book Value of Total Liabilities
  • T5 = Sales / Total Assets
These five ratios are each multiplied by a coefficient before being added together to arrive at the Z-score. 

The standard formula is:

Z = (1.2*T1) + (1.4*T2) + (3.3*T3) + (0.6*T4) + (.999*T5)

Interpreting the Z-score Results

After preforming the calculations above, the end result will be a number that you will then compare to the established Z-score classifications:

  • a Z-score greater than 2.99 puts the company in the safe zone which means bankruptcy is unlikely within the next two years
  • a Z-score between 1.80 and 2.99  puts the company in the grey zone which means it could go either way in the next two years
  • a Z-score below 1.80 puts the company in the “distress zone” which means bankruptcy is likely within the next two years
Some Things to Keep in Mind When Using the Z-score

The Altman Z-scored does not work for financial companies.  So if you are selling to banks, this isn’t an appropriate tool.  Also remember that the formula is modified if you are evaluating private companies and non-manufacturing companies.

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