Predicting Bankruptcy

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Z-Score

Summary of Altman's Z-score Model. Abstract

Edward I. Altman, 1968

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 Z-Score have shown the model is often accurate in predicting bankruptcy (72%-80% reliability)
 

Z-S 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 Z-S 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 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-S 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 non-manufacturing company going 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 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.
 

T I P : Here you can discuss and learn a lot more about Z-Score by Altman.

For the Z-S 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 Z-Score to these liquidity measurement ratios:  Current Ratio  |  Quick Ratio  |  Cash Ratio  |  RAROC

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