How to interpret the Altman Z Score when weighing up a company’s finances

Julie Brownlee, Fsp Invest, 04 Aug. 2014

Tags: altman z score, z score, how to use altman z score, how to investigate company finances, interpreting altman z score

The Altman Z Score is a handy tool to help you evaluate a company’s finances before you invest.

Not only that, most companies provide the Z Score in their annual statements, making it easy to get with no hard number crunching involved.

So how does the Altman Z Score work? And how can you interpret to evaluate a company?

Let’s take a closer look…

How the Altman Z Score works

The Altman Z Score consists of five different formula. To calculate a company’s Z Score, you simply tot these up according to the different weightings each of the formula hold.

Altman named these different formula from X1 to X5 (as you can see in the table below).

The different formula look for different indicators of financial stress. If you want to find out more about the different formula used in the Z Score, go here.

How to interpret the Altman Z Score

You’re looking for a score above 3, Phil Oakley in Money Week explains. This indicates a strong company. Scores of less than 1.8 could indicate that financial problems are afoot.

Have a look at the table below. This shows two London Stock Exchange listed companies, Reckitt Benckiser and Premier Foods.

Table of Z Score calculations

You can see that Reckitt Benckiser comes out on top. It has strong finances as it’s a very profitable company. Whereas Premier Foods is struggling after mounting up years of losses and low profit margins.

The Z Score is a handy tool to use, but as with all financial ratios and measures, don’t limit yourself to one.

To look further into a company’s finances, interest cover is a good one to look at. It measures whether a company’s profits cover its interest bill on debts.

Also make sure you check out a company’s cash flow and hidden liabilities, such as rental payments on buildings.

So there you have it, how to interpret the Altman Z Score when weighing up a company’s finances.

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