The Altman Z-Score Formula Cheat Sheet (DRAFT) by [deleted]

A Z-score is a numerical measur­ement of a value's relati­onship to the mean in a group of values. If a Z-score is 0, it represents the score as identical to the mean score.

Z-scores may also be positive or negative, with a positive value indicating the score is above the mean and a negative score indicating it is below the mean. Positive and negative scores also reveal the number of standard deviations that the score is either above or below the mean.

Z-scores reveal to statis­ticians and traders whether a score is typical for a specified data set or if it is atypical. In addition to this, Z-scores also make it possible for analysts to adapt scores from various data sets to make scores that can be compared to one another accura­tely. Usability testing is one example of a real-life applic­ation of Z-scores.

The Z-score is more commonly known as the Altman Z-score. Edward Altman, a professor at New York Univer­sity, developed and introduced the Z-score formula in the late 1960s as a solution to the time-c­ons­uming and somewhat confusing process investors had to undergo to determine how close to bankruptcy a company was. In reality, the Z-score formula Altman developed ended up providing investors with an idea of the overall financial health of a company.

The Altman Z-score is the output of a credit­-st­rength test that helps gauge the likelihood of bankruptcy for a publicly traded manufa­cturing company. The Z-score is based on five key financial ratios that can be found and calculated from a company's annual 10-K report. The calcul­ation used to determine the Altman Z-score is as follows:

Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

In this equation:
A = Working capita­l/total assets
B = Retained earnin­gs/­total assets
C = Earnings before interest and taxes (EBIT)­/total assets
D = Market value of equity­/book value of total liabil­ities
E = Sales/­total assets

The Z-score also isn't much use for new companies with little to no earnings. These companies, regardless of their financial health, will score low. Moreover, the Z-score doesn't address the issue of cash flows directly, only hinting at it through the use of the net working capita­l-t­o-asset ratio. After all, it takes cash to pay the bills.

Z-scores can swing from quarter to quarter when a company records one-time write-­offs. These can change the final score, suggesting that a company that's really not at risk is on the brink of bankru­ptcy.

Alas, the Z-score is not perfect and needs to be calculated and interp­reted with care. For starters, the Z-score is not immune to false accounting practices. As WorldCom demons­trates, companies in trouble may be tempted to misrep­resent financ­ials. The Z-score is only as accurate as the data that goes into it.

The Z-score also isn't much use for new companies with little or no earnings. These companies, regardless of their financial health, will score low. Moreover, the Z-score doesn't address the issue of cash flows directly, only hinting at it through the use of the net working capita­l-t­o-asset ratio. After all, it takes cash to pay the bills.

Finally, Z-scores can swing from quarter to quarter when a company records one-time write-­offs. These can change the final score, suggesting that a company that's really not at risk is on the brink of bankru­ptcy.