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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Fault in the formula on this page
According to Altman's own article (find references on the English Zscore Wikipedia page) the ratio for X4 for private manufacturers and nonmanufacturers should be:
Book value of equity/Book value of total liabilities
Please correct me if I'm ...






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Compare ZScore model with these other liquidity measurement ratios:
Current Ratio 
Quick Ratio 
Cash Ratio 
RAROC
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