Altman Z Score Explained

The altman z score model is a method to calculate and forecast the possibility
of a business going bankrupt, through use of ratio related to liquidity,
profitability, Solvency activity, etc.

The Altman Z-Score is a widely used metric with wide applications. It is one of
the several credit marking models already in use that combine quantifiable
financial indicators with a small range of variables, which will help us predict
whether a firm will financially fail or go into a bankruptcy stage.

However, over the years since its introduction, the Z-Score has improved to
become one of the reliable predictors of bankruptcy. Many analysts nowadays
use this method because of its wide applications. For example, once Altman re-
evaluated his strategies by examining eighty-six distressed firms from 1969 to
1975 and then 110 bankrupt firms from 1976 to 1995, and 120 bankrupt firms
from 1996 to 1999. The Z-Score had an accuracy level of 82% – 94%, which
was more than that achieved by any of the methodologies.

However, the “garbage in, garbage out” motto applies here. Therefore, if a
firm’s financials, or the input data, need to be more accurate or correct,
the Altman z score model will go wrong and will not be helpful in our analysis
and prediction of bankruptcy.

he five financial ratios used in the calculation of this Altman Z score formula
are as follows:

Financial ratio used The formula for the financial ratio

A Working capital / total assets

B Retained earnings / total assets

C Earnings before interest and task payment /total assets

D The equity’s market value / total assets

E Total sales or Revenues / total assets

 The formula for this model for determining the probability that a firm to close
bankruptcy is:

Altman Z Score formula = (1.2 x A) + (1.4 x B) + (3.3 x C) + (0.6 x D) + (1.0

x E)

 In this model, if the Z value is greater than 2.99, the firm is said to be in the
“safe zone” and has a negligible probability of filing bankruptcy.
 If the Z value is between 2.99 and 1.81, then the firm is in the “gray zone” and
has a moderate probability of bankruptcy.
 And finally, if the Z value is below 1.81, then it is said to be in the “distress
zone” and has a very high probability of reaching the stage of bankruptcy.

Advantages

1. It helps in decision making and analysis.

2. It helps to assess the credit worthiness and solvency of a business.
3. It is very useful in the stock market for analysis. It helps investors to decide
whether to buy a stock or not.

Disadvantages

1. The calculation of the model is dependent on the samples. Therefore, such

instances may only sometimes give clear and precise data, thus doubting
the Altman z score accuracy.
2. Continuous change in the business and financial world is exposing companies to
various forms of risk from time to time, affecting profits. Thus, in such
circumstances, prediction based on past data will not yield the correct result.
3. Altman z score accuracy is also doubtful because is unable to predict when the
business may actually become bankrupt.

Problem 1:

Using Altman‘s Multiple Discriminant Function, calculate Z-score of S & Co.

Ltd., where the five accounting ratios are as follows and comment about its
financial position:

Working Capital to Total Assets = 0.250

Retained Earnings to Total Assets = 50%

EBIT to Total Assets = 19%

Book Value of Equity to Book Value of Total Debt = 1.65,

Sales or Revenue to Total Assets = 3 times

Solution

Hence, Z-score = (1.2x 0.25) + (1.4 x 0.50) + (3.33 x 0.19) + (0.6 x 1.65) + (1.0
x 3) = 0.3+0.70+0.637+.99+3=5.67

Note: As the calculated value of Z-score is much higher than 2.9, it can be
strongly predicted that the company is a non-bankrupt company (i.e., non-failed
company).

Problem 2

The five variables are as follows: X1 = Working Capital to Total Assets = 0.45
X2 = Retained Earnings to Total Assets = 0.25 X3 = EBIT to Total Assets =
0.30 X4 = Market Value of Equity Shares to Book Value of Total Debt= 2.50
X5 = Sales or Revenue to Total Assets = 3 times.

Solution:

Hence, Z-score = (1.2 x 0.45) + (1.4 x 0.25) + (3.3 x 0.30) + (0.6 x 2.50) + (1 x
3) = 0.54 + 0.35 + 0.99 + 1.50 + 3 = 6.38

Note: As the calculated value of Z-score is much higher than 2.99, it can be
strongly predicted that the company is a non-bankrupt company (i.e., non-failed
company).

VAR analysis

What Is Value At Risk (VaR)?

Value at risk is a statistical metric that forecasts the highest possible loss and the
probability of it occurring over a particular period. It is a significant factor in
risk management, financial reporting, financial control, etc. It measures the
magnitude or potential of losses in a portfolio and is helpful for banks and large
corporations to keep an eye on their portfolio value at risk.
 Value at risk is a statistical metric used to calculate the tremendous possible loss
of an asset or a portfolio in a given period and with a particular confidence
level.
 It is calculated to manage risk, aid financial reporting, and financial control.
 Monte Carlo simulation, parametric, and historical methods are widely used to
calculate VaR.
 It is relevant across asset classes like bonds, shares, and currencies, which
makes it a universally accepted metric while selling, buying, or recommending
an asset or investment.

Value at Risk or VaR is a metric that forecasts the highest amount and possible
probability of loss over a specified period, with a given confidence level.
Traditionally, for an investor to measure or gauge the risk in an investment, one
would look at Volatality the primary concern being the loss of money.

The three factors of VaR cover all these concerns efficiently; the three factors
are:

 Time frame
 Confidence level
 Loss amount or percentage of loss.

Despite VaR being a negative figure, it is conventionally considered a positive

number as a negative VaR implies that the portfolio stands a greater probability
of making profits

For example, the one-day VaR of negative Rs.100,000 would mean that the
portfolio would gain greater than $Rs.00,000 the next day.
VaR Methods and Formulas
The variance-covariance method, the Monte Carlo simulation, and the
historical method are the three methods of calculating VaR. But first, let us
understand how to calculate the potential risk through each of the three ways:

Variance-Covariance Method

Also known as the parametric method, this method assumes that the returns
generated from a given portfolio are distributed normally and can be described
by standard deviation and expected returns completely.

The Value at Risk formula:

VaR = Market Price * Volatility

Here, volatility is used to signify a multiple of standard deviation (SD) on a

particular confidence level. Therefore, a 95% confidence will show volatility of
1.65 to the standard deviation.

Monte Carlo Simulation

This method uses a non-linear pricing model, and the quantum of risk is
measured by forecasting different future scenarios in this method. This method
is best suited in situations where many risk measurement problems are
prevalent. It also provides a complete and detailed distribution of the portfolio’s
losses and gains, which might or might not be symmetrical. However, it is more
time-consuming in comparison with other methods of calculation.

Since this method is calculated in a computed manner, it delivers random

possibilities through a code. For example, if the monthly return for three
scenarios ranged between -20% and 25% and two between -15% and -20%,
then the chances of the highest possible loss would be -15%.

Hence, assuming a 95% confidence, the portfolio shall not lose more than 15%
in any given month.

Historical Method

The investor or the analyst provides a start and an end date called, which elicits
a variety of scenarios that show the historical value at risk. Here the variable is
the security’s price with the volatility in the market.

This method computes linear and non-linear possibilities accurately while also
displaying the complete picture of the potential profits and losses in the
portfolio.
The formula is as follows:

VaR Formula = vm (vi/ V(i-1))

Here,

M signifies the days in the historical data taken into consideration

Vi indicates the number of variables on the day in question (the day i)

Calculation

Let us understand the calculation of VaR through the Parametric method:

First, assuming an investor holds only one stock in their portfolio, that of MNO
Corporations for $100,000. Then, taking the volatility daily at 1% and a
confidence level of 95%.

Using the formula, the calculation for this scenario would be:

VaR = Market Price * Volatility

= $100,000 * .01 * 1.65

= $1,650

The calculation signifies a 5% chance that the maximum amount the investor
might lose in one day is $1,650.

Pros and Cons

The statistical metric widely used to understand the risk and the maximum
money they are probable to lose is proof that it has some factors that help them
better understand their portfolios. However, a few demerits point toward the
tool’s updating or development prospects.

Let us understand the pros and cons of VaR through the points below:

Pros

Accessibility
Institutions or investors can understand the overall risk of the investment
through a single numerical result, which makes assessing the risk a relatively
easy task.

Standard Usage

It is a widely used tool to measure the risk factors of portfolios. As a result, it

can be trusted and compared for cross-verification. Investors can also use it
while buying, recommending, or selling an asset, as it is an accepted metric to
signify the risks.

The usage of the calculation is relevant across asset classes like

bonds, derivatives currencies, shares, etc. Therefore, large investment firms
or financial institutions can gauge the risks of their investments across asset
classes and allocate funds according to the VaR report.

Structured

The report produced a structured methodology to educate the investor or analyst

on the risks across investments in an understandable and structured manner,
which makes risk management and financial control a relatively more
straightforward task.

Cons

Application

Some methods, like the Monte Carlo Simulation, are expensive and can be
challenging to teach in the application. Moreover, the calculation only considers
some of the worst possible scenarios. Therefore, organizations conduct stress to
evaluate situations VaR tends to miss.

Different Results

The calculation carried out with different methods could show different results.
Hence, the accuracy of such analysis is always under speculation.

Security

The fact that this calculation provides a probability of an event occurring in the
future is a possibility of that event happening or not. The chance fills investors
with a false sense of security and might turn out to be the other way around

Portfolio Calculation
When calculating the risk of an extensive portfolio, each asset class has to be
calculated separately. The more significant asset classes in the portfolio, the
greater the difficulty of calculating VaR. The correlation between assets also
has to be considered along with the risk-return equation.