What is the Z-factor model?
The Z-factor model (also known as Altman Z-factor, Altman Z-score) is the result of an evaluation model for companies. It is a creditworthiness test. The Z-factor model measures the probability of bankruptcyof a listedmanufacturing company. This means that an investor can use the Z-factor model to obtain information about a company’s risk of insolvency. The Z-factor model is a modification of the traditional Z-score used in statistics. The Z-factor model is also part of the basis of the credit rating. In general, the model uses a company’s profitability, debt, liquidity, solvency and activity to predict whether a company has a high probability of becoming insolvent. The determination of the Z-factor model is based on various financial ratios, which are weighted.
The Z-factor model was inventedin 1967 by finance professor Edward Altman (NYU Stern). The formula has been tested again and again. Altman examined 86 companies at risk of insolvency between 1969 and 1975, 110 between 1976 and 1995, and 120 between 1996 and 1999, with the result that the Altman Z-Score has an accuracy of 82% to 94%. In 2012, he published an updated version, the Altman Z-Score Plus. The Altman Z-Score Plus covers public and private companies, manufacturing and non-manufacturing companies, and US and non-US companies.
Disadvantages of the method are, for example, that the informative value of the method for young companies is severely limited, as the key financial figures of young companies cannot be interpreted in the same way. For example, young companies hardly show any profits. In addition, the method is not based on cash flows. A high Altman Z-score therefore does not indicate that a company is capable of generating cash flows. However, cash flows are important in relation to the solvency of a company.
The calculation of the Altman Z-Score
As already mentioned, the calculation of the Altman Z-Score is based on five key company figures that are weighted using factors. The formula for calculating the Altman Z-Score is as follows:
Altman Z-Score = 1.2*A + 1.4*B + 3.3*C + 0.6*D + 1.0*E
where:
A = Working capital / total capital
B = Retained earnings / total capital
C = EBIT (earnings before interest and taxes) / total capital
D = Market capitalization / total liabilities
E = Turnover / total capital
Originally, a score below 1.8 meant that the company was likely to go bankrupt, while companies with a score above 3 were unlikely to go bankrupt. So by applying the Z-factor model, investors can consider buying 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. In recent years, however, it has become clear that a Z-score of 0 is already a sign of financial difficulties. In a 2019 lecture entitled “50 Years of the Altman Score”, Professor Altman himself noted that more recent data shows that 0 – and not 1.8 – is the level at which investors should be concerned about a company’s financial strength. The lecture can be watched for free on YouTube. So a score between 0 and 1.8 points represents high risk, a score between 1.8 and 3 points represents moderate risk, while a score of 3 or more points represents low risk.
The financial ratios used in the Z-factor model
The Z-factor model is based on five key performance indicators, which are briefly explained below.
- Working capital / total capital: Working capital is made up of current assets less current liabilities. Working capital is used for manufacturing and production. If working capital is too low, companies cannot pay the price for manufacturing and production and are therefore unable to meet their short-term liabilities. However, too much working capital is not always positive either, as high inventories are not absolutely necessary, for example, and the money could have been invested in other ways.
- Retained earnings / total capital: Part of the reserves of corporations flow into retained earnings, which has a positive effect on the solvency of a company. A high level of retained earnings therefore indicates a high profit.
- EBIT / total capital: This key figure measures the productivity of a company, as it indicates how much profit a company can generate in relation to its capital. The ratio thus shows the earning power of a company, which is important for the solvency of a company, as both debt and interest can be paid.
- Market value of equity / total liabilities: The market value of equity (market capitalization) is the maximum liability of a company. The liabilities must be settled in the event of insolvency. This is possible as long as the market value of the equity is higher than the total liabilities.
- Turnover / total capital: This key figure indicates how much turnover a company can generate with each franc of capital. Not every turnover leads to profit. However, a high turnover also indicates the market position of a company and the efficiency of its production.
The Z-factor model and the 2008 financial crisis
The calculation of the Altman Z-Score in 2007 indicated that companies’ probabilities of insolvency had increased. The median Altman Z-score at the time was 1.81. The figure indicated a crisis based on insolvent companies. However, this was not the origin of the financial crisis, but mortgage-backed securities. Nevertheless, 2009 saw the second-highest corporate defaults in history.