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 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 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
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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