How effective is the Z-Score in predicting financial distress? Altman found the Z-Score was 72 per cent accurate in predicting bankruptcy two years before the event and 80-90 per cent accurate one year before.
Here's how the Z-Score is calculated for manufacturing companies.
Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 1T5
T1 = Working capital/ Total assets. It measures liquid assets in relation to the size of a company.
T2 = Retained earnings/ Total assets. It measures profitability that reflects the company's age and earning power.
T3 = Earnings before interest and taxes/Total assets. It measures operating efficiency apart from tax and leveraging factors. It recognises operating earnings as being important to long-term viability.
T4 = Market value of equity/Book value of total liabilities. It adds the market dimension that can show up security price fluctuation as a possible red flag.
T5 = Sales/Total assets. It is a standard measure for total asset turnover.
A Z-Score of greater than 2.99 puts the company in a safe zone; between 1.81 and 2.99, in a grey zone; and less than 1.81, in a distress zone.
The Z-Score for non-manufacturing companies is calculated as follows:
Z = 6.56T1 + 3.26T2 + 6.72T3 + 1.05T4
T1 = Working capital/Total assets
T2 = Retained earnings/Total assets
T3 = Earnings before interest and taxes/Total assets
T4 = Market value of equity/Total liabilities
For such companies, a Z-Score of greater than 2.6 is safe zone; between 1.1 and 2.6, grey zone; and less than 1.1, distress zone.
In the first table you can see some of the safest stocks ranked on Z-Score in the Indian markets today. In the other table are some of the worst performers on the Z-score. Altman highlighted that the average Z-Score of companies that are likely to report financial distress in future is -0.25. The table shows some companies that cross even that landmine.
There were other interesting observations that we made using the Z-Score exercise. For instance, the sector that is the least likely to report a low Z-Score is technology, followed by services, FMCG and healthcare - in that order.
On the other end, the sector that throws up the maximum number of potential red flags is, without surprise, realty. Electric generation, distribution and electric-equipment manufacturing companies form the second largest group of companies with a low Z-Score. Construction makes its presence in the third place. Cement comes next and is followed by the crude-oil sector.