Z-Score (Altman)

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Predicting bankruptcy. Explanation of Z-Score formula of Altman. ('68)

The Z-Score formula for predicting bankruptcy of Edward Altman is a multivariate formula for a measurement of the financial health of a company and a powerful tool to diagnose the probability that a company will go bankrupt within a 2 year period. Studies measuring the effectiveness of the Z-Score have shown the model is often accurate in predicting bankruptcy (72%-80% reliability).
 

The Z-Score was developed in 1968 by Dr. Edward I. Altman, Ph.D., a financial economist and professor at New York University's Stern School of Business.
 

Composition of the Z-Score

The Z-Score bankruptcy predictor combines five common business ratios, using a weighting system calculated by Altman. Thus it determines the likelihood that a company will go bankrupt. It was derived based on data from manufacturing firms, but has since proven to be also effective (with some modifications) in determining the risk that a services firm will go bankrupt.

Analyzing the results of the Z-Score method

How should the results be judged? It depends:

• Original Z-Score [For Public Manufacturer] If the score is 3.0 or above - bankruptcy is not likely. If the Score is 1.8 or less - bankruptcy is likely. A score between 1.8 and 3.0 is the gray area. Probabilities of bankruptcy within the above ranges are 95% for one year and 70% within two years. Obviously, a higher score is desirable.
• Model A Z'-Score [For Private Manufacturer] Model A of Altman's Z-Score is appropriate for a private manufacturing firm. You should not apply Model A to other companies. A score of 2.90 or higher indicates that bankruptcy is not likely. But a score of 1.23 or below is a strong indicator that bankruptcy is likely. Probabilities of bankruptcy in the above ranges are 95% for one year and 70% within two years. Obviously, a higher score is desirable.
• Model B Z'-Score [For Private General Firm] Edward Altman developed this version of the Altman Z-Score to predict the likelihood that a privately owned non-manufacturing company will go bankrupt within one or two years. Model B is appropriate for a private general (non-manufacturing) firm. Model B should not be applied to other companies. A score of 1.10 or lower indicates that bankruptcy is likely, while a score of 2.60 or higher can be an indicator that bankruptcy is not likely. A score between the two is the gray area. Probabilities of bankruptcy in the above ranges are 95% for one year and 70% within two years. Again, obviously, a higher score is desirable.

For the Z-Score Formula, see the figure on the right. Note the variations for public and private companies.

Book: John B. Caouette, Edward I. Altman, Paul Narayanan - Managing Credit Risk -

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Z-Score Forum

- Sweden

Fault in the formula on this page

"According to Altman's own article (find references on the English Z-score Wikipedia page) the ratio for X4 for private manufacturers and non-manufacturers should be: Book value of equity/Book value of total liabilities Please correct me if I'm wrong. "

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Chris Bennett - Singapore

Applicability of Z Score to Financial Institutions?

"I've read that the Altman Z score shouldn't be used for financial firms. Is this correct? Thank you."

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Aditi - UK

Z score of 1000

"Can z score be 1000...?"

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- Colombia

Predicting Bankruptcy of SMEs

"Altman Z.Score has been made for big companies but does not include SME. This kind of companies usually has different environment, behavior and variables. What method can be used here to predict bankruptcy?"

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Compare Z-Score model with these other liquidity measurement ratios:  Current Ratio  |  Quick Ratio  |  Cash Ratio  |  RAROC

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