Altman's Model for Predicting Bankruptcy
is a multivariate formula for a measurement
of the financial health of a company and a powerful diagnostic tool that
forecasts the probability of a company entering bankruptcy 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)
ZS 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.
The ZS bankruptcy predictor
combines five common business ratios, using a weighting system
calculated by Altman to determine the likelihood of a company going
bankrupt. It was derived based on data from manufacturing firms, but has
since proven to be effective as well (with some modifications) in
determining the risk a service firm will go bankrupt.
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 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
ZS is appropriate for a private manufacturing firm. Model A should
not be applied to other companies. A score of 2.90 or above 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 to predict the likelihood
of a privately owned nonmanufacturing company going 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 above 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 ZS 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 
Compare ZScore to these liquidity
measurement ratios: Current Ratio

Quick Ratio 
Cash Ratio 
RAROC
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