Straits Times featured an interesting article on 17 July 2020 about Edward Altman warning investors that more companies are going bankrupt in 2020.
Edward Altman, a professor from The New York University (NYU), developed the “Altman Z-score”. It is a well-known and widely used formula for predicting corporate insolvencies.
What is Altman Z-Score?
Edward Altman published the Z-score in 1968. It is a formula to determine whether a company is headed for bankruptcy. The formula was initially used for manufacturing companies. It was later enhanced to include non-manufacturing ones.
In a series of subsequent tests over the next 31 years (till 1999), the score was approximately 80%–90% accurate in predicting bankruptcy one year before the event.
How to calculate?
The formula takes into account profitability, leverage, liquidity, solvency, and activity ratios.
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
- A = working capital / total assets
- B = retained earnings / total assets
- C = earnings before interest and tax / total assets
- D = market value of equity / total liabilities
- E = sales / total assets
Interpretation and usage
A company with an Altman Z-score close to 1.8 might be headed for bankruptcy. On the other hand, a score closer to 3 suggests a company is in a solid financial position.
Investors use Altman Z-scores to evaluate the company’s underlying financial strength. This can help them determine whether to buy or sell a stock. Specifically, investors may consider buying a stock if its Altman Z-Score value is closer to 3 and selling a stock if the value is closer to 1.8.
Prediction in 2020
Some interesting facts according to Edward Altman:
“More than 30 American companies with liabilities exceeding US$1 billion (S$1.39 billion) have already filed for Chapter 11 bankruptcy protection since the start of January, and that number is likely to top 60 by year end after businesses piled on debt during the pandemic, according to Z-score creator Edward Altman, who is professor emeritus at NYU’s Stern School of Business.
To combat the COVID-19 pandemic, the US Federal Reserve has provided unprecedented support to the markets by injecting liquidity. The Federal Reserve’s support included buying corporate bonds from companies, even those with junk credit ratings.
This year, companies globally have sold a record USD2.1 trillion of bonds. The stimulus-fueled rally helped to keep companies afloat. However, it may not be sustainable.
Edward Altman rightfully pointed out:
“When there is an increase in insolvency risk, what you do not need is more debt. You need less debt.
Where to find a company’s Altman Z-score
One of the free website which i use is Gurufocus. You will be able to find the Z-score under the Summary page tab. Below is a screenshot using Apple as an example:
I have looked at a few of the companies in distress and noticed the Z-scores are indeed very low (below the 1.8 level).
Chesapeake Energy Corp: negative 6.34
Delta Airlines: 0.55
JC Penny: 0.89
Debt and leverage are a double-edged sword. During times of distress, it is unwise for companies to take on additional debt. Doing so creates extra burden on companies as they need additional cashflow to service the debt.
For individual investors, always invest with money you can afford to lose. You should never borrow money to invest. The last thing you want is to lose sleep and even your pants when the market goes in the wrong direction.