The Altman Z-Score: Is it possible to predict corporate bankruptcy using a formula?

Developed in 1968, the Altman Z-Score seeks to estimate corporate bankruptcy risk

In Brief
The Altman Z-score is a combination of five weighted business ratios that is used to estimate the likelihood of financial distress.

Background to the Z-Score

The Z-Score was developed in 1968 by Edward I. Altman, an Assistant Professor of Finance at New York University, as a quantitative balance-sheet method of determining a companys financial health. A Z-score can be calculated for all non-financial companies and the lower the score, the greater the risk of the company falling into financial distress. The original research was based on data from publicly held manufacturers (66 firms, half of which had filed for bankruptcy). Altman calculated 22 common financial ratios for all of them and then used multiple discriminant analysis to choose a small number of those ratios that could best distinguish between a bankrupt firm and a healthy one. To test the model, Altman then calculated the Z Scores for new groups of bankrupt and nonbankrupt but sick firms (i.e. with reported deficits) in order to discover how well the Z Score model could distinguish between sick firms and the terminally ill. The results indicated that, if the Altman Z-Score is close to or below 3, it is wise to do some serious due diligence before considering investing. The Z-score results usually have the following "Zones" of interpretation: 1. Z Score above 2.99 -Safe Zones. The company is considered Safe based on the financial figures only.

2. 1.8 < Z < 2.99 -Grey Zones. There is a good chance of the company going bankrupt within the next 2 years of operations.

3. Z below 1.80 -Distress Zones. The score indicates a high probability of distress within this time period.

The Z-score has subsequently been re-estimated based on other datasets for private manufacturing companies, as well as non-manufacturing / service companies.

Does the Altman Z-Score Work?

In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years prior to the event. In subsequent tests over 31 years up until 1999, the model was found to be 80-90% accurate in predicting bankruptcy one year prior to the event. In 2009, Morgan Stanley strategy analyst, Graham Secker, used the Z-score to rank a basket of European companies. He found that the companies with weaker balance sheets underperformed the market more than two thirds of the time. Morgan Stanley also found that a company with an Altman Z-score of less than 1 tended to underperform the wider market by more than 4%.

Calculation / Definition
For public companies, the z-score is calculated as follows: Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5. 1. X1 = Working Capital / Total Assets. This measures liquid assets as firm in trouble will usually experience shrinking liquidity. 2. X2 = Retained Earnings / Total Assets. This indicates the cumulative profitability of the firm, as shrinking profitability is a warning sign. 3. X3 = Earnings Before Interest and Taxes / Total Assets. This ratio shows how productive a company in generating earnings, relative to its size. 4. X4 = Market Value of Equity / Book Value of Total Liabilities. This offers a quick test of how far the company's assets can decline before the firm becomes technically insolvent (i.e. its liabilities exceed its assets). 5. X5 = Sales/ Total Assets. Asset turnover is a measure of how effectively the firm uses its assets to generate sales.

Deconstructing

the Z-Score

Working Capital to Total Assets Working capital is a companys current assets less its current liabilities and measures a companys efficiency and its short-term financial health. Positive working capital means that the company is able to meet its short-term obligations. Negative working capital means that a companys current assets cannot meet its short-term liabilities; it could have problems paying back creditors in the short term, ultimately forcing it into bankruptcy. Companies with healthy, positive working capital shouldnt have problems paying their bills. Retained Earnings to Total Assets The retained earnings of a company are the percentage of net earnings not paid out as dividends; they are retained to be reinvested in the firm or used to pay down debt. Retained earnings are calculated as follows: Beginning retained earnings + net income (net loss) dividends paid The ratio of retained earnings to total assets helps measure the extent to which a company relies on debt, or leverage. The lower the ratio, the more a company is funding assets by borrowing instead of through retained earnings which, again, increases the risk of bankruptcy if the firm cannot meet its debt obligations. Earnings Before Interest & Taxes to Total Assets This is a variation on return on assets, which is net income divided by total assets. This ratio assesses a firms ability to generate profits from its assets before deducting interest and taxes. Market Value of Equity to Total Liabilities The ratio of market value of equity to total liabilities shows how much a companys market value (as measured by market capitalization, or share price times shares outstanding) could decline before liabilities exceeded assets. Unlike the other ratio components used by the Z-Score, market value isnt based purely on fundamentalsthe market capitalization of a firm is an indication of the markets confidence in a companys financial position. Generally speaking, the higher the market capitalization of a company, the higher the likelihood that the firm can survive going forward. Sales to Total Assets The ratio of sales to total assets, more commonly referred to as asset turnover, measures the amount of sales generated by a company for every dollars worth of its assets.

In other words, asset turnover is an indication of how efficiently a company is as using its assets to generate sales. The higher the number the better, while low or falling asset turnover can signal a failure by the company to expand its market share.

Conclusion
The Z-Score is another tool investors can use to monitor the safety of their investments. As we saw with Borders, a steadily declining score can signal underlying problems with a company. That being said, it is still subject to shortcomings faced by all financial metrics. At a minimum, however, a low or declining Z-Score should spur you to conduct more in-depth analysis to seek out the root cause.

Altman Z-Score
Meaning of Altman Z-Score The Altman Z-Score is an analytical representation created by Edward Altman in the 1960s which involves a combination of five distinctive financial ratios used for determining the chances of bankruptcy amongst companies. Most commonly, a lower score reflects higher chances of bankruptcy. Formula for Z-Score The Z-Score can be characterized as a linear combination of 4-5 common business ratios The formula for Z-Score and prediction of bankruptcy was given by Edward I. Altman in 1968. This formula for Altman Z-Score is helpful in calculating and predicting the probability that a company will go into bankruptcy within two years. 4-factor model of the Altman Z-score (for a private non-manufacturer): Z-score = 6.56T1 + 3.26T2 + 6.72T3 + 1.05T4 where, T1 = Working Capital / Total Assets T2 = Retained Earnings / Total Assets T3 = Earnings Before Interest and Taxes / Total Assets T4 = Equity / Total Liabilities Zones of Discrimination:

1.1 or less Distress Zone from 1.1 to 2.6 Grey Zone 2.6 or more Safe Zone

5-factor model of the Altman Z-score (a for private manufacturing firms): Z-score = 0.717T1 + 0.847T2 + 3.107T3 + 0.42T4 + 0.998T5 where, T1 = Working Capital / Total Assets T2 = Retained Earnings / Total Assets T3 = Earnings Before Interest and Taxes / Total Assets T4 = Equity / Total Liabilities T5 = Sales / Total Assets Zones of Discrimination:

1.23 or less Distress Zone from 1.23 to 2.9 Grey Zone 2.9 or more Safe Zone

Interpretation of Altman Z-Score The Z-Scores are helpful in predicting corporate defaults as well as an easy-to-calculate measure of control for financial distress status of companies in academic studies. A Z-Score above 2.6 (2.9) indicates a company to be healthy. Besides, such a company is also not likely to enter bankruptcy. However, Z-Scores ranging from 1.1-2.6 (1.23-2.9) are taken to lie in the grey area. Altmans Z-Score indicator can be easily calculated using ReadyRatios financial analysis software which also makes the conclusion on the result. Accuracy and effectiveness In the initial stages, the Altman Z-Score was found to be 72% exact in predicting bankruptcy two years preceding the event, including a Type II error (false positives) of 6%. However, the model was found to be about 80-90% accurate in the process of predicting bankruptcy one year preceding the event, in a series of ensuing tests including three distinctive time periods over the next 31 years. However, a type II error, classifying the company as bankrupt while it is not going so, of 15-20% was also included in these tests. The approach of Altmans Z-Score formula has achieved ample acceptance by management accountants, auditors, database systems, and courts used for loan evaluation. Besides the approach of this formula has been used in an assortment of countries and contexts, although it had been initially designed for publicly held manufacturing firms featuring assets of more than $1 million.