In 1968, Edward Altman, Professor of Finance at New York University, came up with a formula to determine if companies are financially sound. This is now known as the Altman Z-score. It is a combination of five business ratios that are shown to predict bankruptcy. The five ratios are weighted in the formula based on their predictive ability of a bankruptcy.
- Working Capital / Total Assets measures liquid assets in relation to the size of the company. A company can go into financial difficulties if it does not have enough liquidity.
- Retained Earnings / Total Assets measures long-term profitability in relation to the size of the company. A profitable company usually has high retained earnings.
- Earnings Before Interest and Tax / Total Assets measures management’s ability to generate earnings in relation to the size of the company.
- Market Value of Equity / Book Value of Total Liabilities measures the degree of borrowings/leverage. The lower the ratio, the greater the leverage.
- Sales / Total Assets measures how well the company is generating sales from the use of its assets, another sign of management effectiveness.
Morgan Stanley ranked a basket of companies by their Z-scores and found that companies with low Z-scores underperformed the market more than two-thirds of the time. Research has also shown that companies with high Z-scores do better.