The
ZScore 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 ZScore have shown
the model is often accurate in predicting bankruptcy (72%80% reliability).
The ZScore 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 ZScore
The ZScore 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 ZScore method
How should the results be judged? It depends:
 Original ZScore [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 grey 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
ZScore 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 ZScore to predict the likelihood that a privately
owned nonmanufacturing company will go bankrupt within one or two years.
Model B is appropriate for a private general (nonmanufacturing) 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 ZScore 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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Compare ZScore model with these other liquidity measurement ratios:
Current Ratio 
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Cash Ratio 
RAROC
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