Stock Fundamentals

DIY Investing: How you should use Altman Z-score in assessing stocks

Satya Sontanam BL Research Bureau | Updated on October 16, 2021

Note that low Z-scores for FY21 could partially be due to Covid impact

With stock markets at record valuation levels, risk of correction is higher and investors holding stocks that are financially strong will likely see a lower impact than those invested in financially distressed companies. To screen out such weak companies, the DIY investors can make use of the Altman Z-score that predicts the likelihood of an entity’s financial distress. Developed by Edward Altman, Professor at New York University, the score assesses the state of credit health of the company by analysing five ratios based on the financial statistics of the company.

In this DIY series, we discuss how the score works and the list of entities that one has to take note of, based on the score arrived at using recent financials.

The criteria

The Z-score is a score given to a company using a formula based on the five important ratios; Z (score) = 1.2* (working capital/total assets) + 1.4 * (retained earnings/total assets) + 3.3 * (earnings before interest and taxes/total assets) + 0.6 * (book value of equity/book value of total liabilities) + 1.0 * (sales/total assets).

The first component of the formula — working capital/total assets — measures the net liquid assets of the firm relative to the total capitalisation. The formula takes into account shrinking current assets in relation to total assets as it is generally a reflection of operating losses generated by the company.

While the second — retained earnings/total assets — measures the cumulative profitability over time that reflects the earning power, the third component — EBIT/total assets — assesses the operating efficiency of the company.

The book value of equity/book value of total liabilities (measured by book value of equity plus debt) identifies how much the firm’s assets can decline in value before the liabilities exceed the assets and the firm becomes insolvent. Finally, the last component — sales/total assets — which is a standard measure for total asset turnover, illustrates the sales-generating-ability of the firm’s assets.

Generally , companies with Z-score close to or greater than 2.99 are considered in safe zone while those with less than 1.81 are seen to bein the distress zone. According to a report by Edward Altman in 2000, in a series of tests over three decades (until 1999), the model was found to be 82–94 per cent accurate in predicting default (using a cut-off score of 2.67) one year before the event.

Note that the Z-score was originally developed for manufacturing companies but is applied across many sectors to gain perspectives.

Low Z-score entities

Using the Capitaline database, we filtered stocks that have least Z-score amongst the NSE 500 companies (excluding companies from banking, finance and insurance segments) based on the financial metrics as on March 31, 2021.

The company that tops the list is Tata Tele Maharashtra, a telecom service provider, which has been a loss-making company with a negative net worth and high debt. Now, the Tata group is looking at reviving Tata Teleservices and that could be the reason why the stock has touched the upper circuit several times in the last one year

The next in the list is Alok Industries, which was one of the first twelve accounts, released by Reserve Bank of India for insolvency proceedings in June 2017. Being taken over by a consortium of Reliance Industries and JM Financial Asset Reconstruction in 2020, the firm has been in the line of narrowing down its losses.

Sun Pharma Advanced Research or SPARC, the next in the list, is a subsidiary of Sun Pharma and is into pharmaceutical research and development. The low Z-score for the entity could be due to the nature of its business which has long gestation resulting in generating losses for quite some time.

One obvious company in the list is Vodafone Idea, due to inability to push through tariff hikes in a fiercely competitive telecom market and the AGR issue. It been facing financial distress for quite a few years now and has been one of the top companies with low Z-score. Recent government relief measures for the telecom sector offer a glimmer of hope, though.

Suzlon Energy is another name in the list weighed down with leverage problems since early part of last decade, although it appears to be on the mend now. Similar is the case with GMR Infra.

Other companies with low Z- score are from industries that have been severely impacted by Covid-19 — entertainment (Inox Leisure), air transport services (Interglobe Aviation) and hotels and restaurants (Lemon Tree Hotel and Mahindra Holidays).

Applicability in current context

For some of the companes in the list, the low Z-score is partially due to a one-off event of Covid-19 that significantly impacted earnings and profitability in FY21. However, prospects are improving, looking ahead, with restrictions easing and economies on a rebound. This needs to be considered before making decisions based on this metric.

Published on October 16, 2021

Follow us on Telegram, Facebook, Twitter, Instagram, YouTube and Linkedin. You can also download our Android App or IOS App.

This article is closed for comments.
Please Email the Editor

You May Also Like