Imagine you're a small business advisor helping your clients navigate financial bumps. One brick-and-mortar store you've been working with for years is experiencing declining sales and struggling to pay their bills. As an advisor, you need to accurately predict their risk of bankruptcy and help them make informed decisions.
One of the tools at your disposal is the Altman Z-score, a formula developed in the 1960s by New York University Professor Edward I. Altman.
The Z-score is calculated using five financial ratios derived from a company's annual reports:
These ratios are then applied to Altman's formula to calculate the final Z-score which can indicate the risk of bankruptcy.
The range of Z-score can be interpreted as follows:
For the struggling brick-and-mortar store, you begin by collecting their annual financial statements. You calculate each ratio, and plug those numbers into Altman's Z-score formula. Let's say the resulting score is 1.6. This, unfortunately, indicates a high probability of bankruptcy unless the company takes immediate action to turn things around.
Altman's Z-score can be a useful tool for small business advisors, creditors, investors, and even company executives for assessing a firm's financial health and the risk of insolvency. It offers a concrete and quantitative way to inform crucial financial decisions and take preventive measures against bankruptcy.