Question

Suppose that the financial ratios of a potential borrowing firm took the following values: X1 = Net working capital/Total assets = 0.20, X2 = Retained earnings/Total assets = 0.30, X3 = Earnings before interest and taxes/Total assets = 0.21, X4 = Market value of equity/Book value of long-term debt = 0.50, X5 = Sales/Total assets ratio = 0.8. Calculate the Altman’s Z-score for this firm.

Answer 1

Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

• A = working capital / total assets
• B = retained earnings / total assets
• C = earnings before interest and tax / total assets
• D = market value of equity / total liabilities
• E = sales / total assets

Altman Z- Score = 1.2 * 0.2 + 1.4 * 0.3 + 3.3 * 0.21 + 0.6 * 0.5 + 1 * 0.8 = 2.453.

Investors can use Altman Z-scores to determine whether they should buy or sell a stock if they're concerned about the company's underlying financial strength. Investors may consider purchasing a stock if its Altman Z-Score value is closer to 3 and selling or shorting a stock if the value is closer to 1.8.