Applying Z-Score in Audit Case

Introduction

In 1968 Edward Altman, a New York University Finance Professor, created and published the Altman Z-score. The Altman Z-score is the output of a credit-strength test using five financial ratios that produces a measure of a company’s financial distress that gauges a company’s likelihood of bankruptcy (2008, Investopedia). In this report, I will calculate Altman’s Z-score for Nordstrom Inc., in order to determine their ability to continue as a going concern in 2016.

Calculating and Interpreting a Z-Score

Altman’s Z-score is the output of a formula using five financial ratios that produces a measurement of a company’s likelihood of bankruptcy (Graham Investor, 2009). The five financial ratios used in this formula (X1, X2, X3, X4, X5) are the following. X1 is Working Capital/Total Assets, which measures liquid assets in relation to the size of the company. X2 is Retained Earnings/Total Assets, which measures profitability reflecting the company’s age and earning power. X3 is EBITDA/Total Assets, which measures operating efficiency apart from tax, leveraging, depreciation, and amortization factors. X4 is Market Value of Equity/Book Value of Total Liabilities, which takes into account market dimensions of security price fluctuations as a possible red flag. And lastly, X5 is Net Sales/Total Assets, which is a standard measure for total asset turnover (Investopedia, 2011). The composition of these financial ratios in this formula results the following equation:

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5

The resulting Z-score, or the outcome of the above equation, has three specific relevant ranges. The first range is from 0 to 1.8, which signifies that the company may be in financial distress (Investopedia, 2011). The lower the number within this range, the more severe the financial distress may be (Investopedia, 2011). The next range is 1.81 to 2.99, which signals a moderate financial status. The lower the number within this range, the more likely...