What is Altman Z-score? Explain how it is it used to study default risk?

What is Altman Z-score? Explain how it is it used to study default risk? 

Ans. The Altman Z-Score actually consists of five performance ratios that are combined into a single score. These five ratios are weighted using the following formula: Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E Where: 

A = working capital ÷ total assets 

B = retained earnings ÷ total assets 

C = earnings before interest and taxes ÷ total assets 

D = market value of equity ÷ total liabilities 

E = sales ÷ total assets 

The biggest drawback, as is the case with all financial analysis, is that the Z-Score is reliant on the quality of the underlying financial statement data. If a company is “cooking the books,” its financial statement data is not a true representation of the strength (or lack thereof) of the company. It is used to judge bankrupt and hence default risk. If the score below 1.8 means the company is probably headed for bankruptcy, while companies with scores above 3.0 are not likely to go bankrupt. The lower/higher the score; the lower/higher the likelihood of becoming bankrupt.