The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University. The formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company.
The Z-score is a linear combination of four or five common business ratios, weighted by coefficients. The coefficients were estimated by identifying a set of firms which had declared bankruptcy and then collecting a matched sample of firms which had survived, with matching by industry and approximate size (assets).
- The Z-score has 5 inputs:
- T1 = Working Capital / Total Assets.
- T2 = Retained Earnings / Total Assets.
- T3 = Earnings Before Interest and Taxes / Total Assets.
- T4 = Market Value of Equity / Book Value of Total Liabilities.
- T5 = Sales / Total Assets.
The inputs show above then come together using the following formula:
Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5
Calculation for Sears
The following data, obtained from SHLD's latest 10-K, is necessary to make the Z-score calculation:
- Current assets: $10244 million.
- Current liabilities: $9212 million.
- Total assets: $21381 million.
- Retained earnings: $1865 million.
- EBIT: - $852 million (the reported EBIT was -$1501 million, but I removed $649 million in impairment charges)
- Market capitalization: $8783 million.
- Total liabilities: $17040 million.
- Revenues: $41567 million.
Using this data we get the following parcels:
- 1.2 * T1 = 0.058
- 1.4 * T2 = 0.122
- 3.3 * T3 = - 0.131
- 0.6 * T4 = 0.309
- 0.999 * T5 = 1.942
This gives us an Altman Z-score of 2.30.
Interpretation and Conclusion
The Altman Z-score is interpreted according to the following ranges (source: Creditworthy.com):
3.0 or more,
Most likely safe based on the financial data. Of course, mismanagement, fraud, economic downturns, and other factors may cause an unexpected reversal.
2.7 to 3.0,
Probably safe to predict survival, but this is a portion of the gray area and is below the threshold of relative safety.
1.8 to 2.7
Likely to be bankrupt within two years. This is the lower portion of the gray area and dramatic action may be required to effect survival.
Highly likely headed for bankruptcy. Rarely would a firm be expected to recover from a financial condition generating this or lower scores.
So, Sears' Z-score now means that Sears is likely to be bankrupt within 2 years, even though its ratio benefits greatly from the asset turnover implied in its large revenues versus assets. It also benefits from the fact that it accumulated retained earnings in the past - something that's now being eaten by losses. With the predictable increase in losses and unrelenting drop in revenues, it won't take much for Sears to fail.
Disclosure: I am short SHLD.