The Altman Z-score model is aquantitative formula designed by Edward Altman. It is adopted by public orprivate companies to measure a financial health and worthiness of a company (Cao,2016). In other word, it is a financial model to anticipate the likelihood offinancial distress. It consists of five financial analysis ratios to determinethe probability of bankruptcy among companies by using some basic terms infinancial statements such as assets, liabilities, equity, earnings and others (InvestingAnswers,2017). Altman Z-score has two outcomes which is positive and negativeindicators. If the company has a Z-Score that is positive and above 3.0, itindicates that the likelihood of bankruptcy of a company is small and unlikelyto go for bankrupt is low.
Oppositely, if the Z-Score of a company is below 1.8or negative, it indicates the higher probability that a company will go bankrupt(Rouse, 2014). In summary, the higher the Altman Z-score, it is better for acompany. 1. Current ratioThe current ratio is a liquidityratio to evaluate the ability of a company to pay its short-term obligationsbased on its current assets when they become due within a year. It is alsoknown as working capital ratio.
It is a famous method that used by companies todetermine the short-term solvency position in business (Accountingformanagement,2012). In others word, it measure the adequacy of current assets to meet its currentliabilities to determine whether it has sufficient resources to pay for itsdebt in 12 months. In business, the higher the current ratio is better andconsidered as a positive sign for a company. It shows that the company is morecapable to pay its obligations and no short-term liquidity problems. Commonly,2:1 is considered as a comfortable and acceptable level for all companies (CCDConsultants, 2015). However, if the current ratio is too high which is morethan 2, it indicates that the company is not efficient in using its currentassets. Oppositely, the current ratio that is less than 1.1 indicates thecompany is having the financial difficulty in meeting its current obligations (Peavler,2017).
2. Quick ratioQuick ratio is also known as acidtest ratio, indicates the short-term liquidity of a company. It measures therelationship between quick assets and current liabilities which evaluates theability of a company to utilize its quick assets such as cash, marketablesecurities, and accounts receivable to settle its short-term liabilities (Borad,2017). For a business, the ideal quick ratio is 1:1.
It shows that the companyis able to meet its current debt obligations by using its current cash on hand (CCDConsultants, 2015). However, the company should not keep too much cash on handbecause indicates the company does not use the cash on hand effectively. Incontrast, the quick ratio that is less than 1:1 indicates that the company ishaving financial difficulty and does not have enough cash on hand to cover itsshort-term debt obligations.3. Debts to Total AssetsThe debts to total assets ratio isused to determine the portion of a company’s assets that are financed by debtfinancing rather than the equity financing. In other words, it is a financialleverage ratio to shows a total assets’ percentage of a company that wasfinanced by debt, lenders, and creditors instead of funded from investors (Averkamp,2017).
If the ratio is above 1%, it means that the company is facing troublebecause of borrowing too much funds from creditors and lenders. The company isputting itself at risk of unable to pay its backs on time to creditors as wellas bankruptcy (Peavler, 2017). Oppositely, if the ratio is lower than 1%, itshows that the company is borrowed little funds from debt financing as comparedto total assets. The low ratio indicates that most of the funding is fromequity financing and signals a stability if a company (Borad, 2017).4.
Debts to EquityThe debts to equity ratio is alsoknown as gearing ratio which measure the weight of total debt of a companyagainst the total equity of a company. The ratio shows the company percentageof financing that arises from creditors rather than investors financing (MyAccounting Course, 2017). Generally, a high percentage of debts to equity whichis more than 50% indicate that there is greater risk of insolvency and bankruptfaced by the company and unable to generate adequate cash to pay off debtobligations (InvestingAnswers, 2017). In contrast, the low ratio or less than50% signals that the company adopts a more financially stable business whichthe assets portion provided by shareholders or investors is greater thancreditors (Accountingformanagement, 2017). 5. Operating Cash Flow to TotalLiabilitiesOperating cash flow to totalliabilities ratio is used to measure the cash generated from the ordinarycourse of business.
Generally, it is adopted by the company to determine theability to pay its liabilities and its liquidity position (Bragg, 2014). If theratio is 1 and above, it is within the acceptable range which indicates theliquidity position of the company is better. Also, the company’s financialflexibility is better and able to pay its liabilities. Oppositely, if theoperating cash flow to total liabilities is below 1, it shows that the companyis unable to cover its current liabilities by the operating cash flowgenerated. Moreover, it indicates that the company has financial distress(Accounting Capital, n.
d.) In summary, the higher the operating cash flow tototal liabilities is better.6. Interest Coverage ratioInterest coverage ratio is used tomeasures the ability of a company to make interest payments on debts in atimely manner. In other words, the interest coverage ratio is adopted by thecompany to determine the numbers of times that could make on the payments oninterest on its debt with the earnings before interest and taxes (EBIT) (Bragg,2017). If the ratio is greater than 1, it indicates that the company is able topay the interest expenses with sufficient funds and there is still has additionalearnings for the principles payments. However, if the ratio is less than 1, itshows that the company is unable to make payments on interest due toinsufficient funds.
Thus, the higher the interest coverage ratio is better fora company (MyAccountingCourse, 2017).