Definition:

Altman's Z Score is a financial model used to predict the likelihood of a company going bankrupt within the next two years. It combines various financial ratios to assess the financial health of a company.

Formula:

Z = 1.2 * (Working Capital / Total Assets) + 1.4 * (Retained Earnings / Total Assets) + 3.3 * (Earnings Before Interest and Taxes / Total Assets) + 0.6 * (Market Value of Equity / Total Liabilities) + 1.0 * (Sales / Total Assets)

How to use the metric:

The Z Score is used to evaluate the financial stability of a company. A Z Score above 2.99 suggests a low probability of bankruptcy, a score between 1.81 and 2.99 indicates a moderate risk, and a score below 1.81 suggests a high risk of bankruptcy.

Limitations:

The Altman's Z Score may not accurately predict bankruptcy for companies in industries with unique financial structures or for companies outside the manufacturing sector. It also relies on historical data, which may not reflect current or future conditions.

Applies to:

The Z Score works best for manufacturing companies, as it was originally developed with this industry in mind.

Doesn't apply to:

The Z Score does not apply well to financial institutions and service-based companies because these industries have different financial structures and leverage ratios that the model does not account for.

Summary:

Altman's Z Score is a useful tool for assessing the bankruptcy risk of manufacturing companies by analyzing key financial ratios. However, its applicability is limited for companies in non-manufacturing sectors, particularly financial and service industries.