Altman Z Score

What is the Altman Z Score?

Altman Z score is a type of Z score, which was published by Edward I. Altman in 1968 as a Z score formula, used to predict the chances of bankruptcy. This methodology can be used to predict the chance of a business organization to move into bankruptcy within a given time, which is mostly about 2 years.

This method is successful in predicting the status of financial distress in any firm. Altman Z score can help in measuring the financial health of a business organization by the use of multiple balance sheet values and corporate income.

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Altman Z Score Formula

This formula is basically designed for publicly held manufacturing firms with values of more than $ 1 million of net worth.

The 5 financial ratios used in the calculation of this Altman Z score formula are as follows:

Financial ratio usedThe formula for the financial ratio
AWorking capital / total assets
BRetained earnings / total assets
CEarnings before interest and task payment /total assets
DThe equity’s market value / total assets
ETotal sales / total assets

The formula for this model for determining the probability that a firm to close bankruptcy is:

Altman Z Score formula = (1.2 x A) + (1.4 x B) + (3.3 x C) + (0.6 x D) + (0.999 x E)

  • In this model, if the Z value is greater than 2.99, then the firm is said to be in the “safe zone” and has a negligible probability of filing bankruptcy.
  • If the Z value is between 2.99 and 1.81, then the firm is said to be in the “grey zone” and has a moderate probability for bankruptcy.
  • And finally, if the Z value is below 1.81, then it is said to be in the “distress zone” and has a very high probability of reaching the stage of bankruptcy.

Application of Altman Z Score in predicting bankruptcy

  • The value of the Altman Z score is generally around – 0.25 for firms that have the highest probability of going bankrupt. On the other hand, for firms having the least probability of facing bankruptcy, the value of the Altman Z score value is as high as + 4.48.
  • This formula is helpful for investors to determine if they should consider buying a stock or sell some of the stocks they have. Generally, the Altman Z score below 1.8 denotes that the firm is under the chance of getting into bankruptcy. On the other hand, the firms with the Altman Z score above 3 are deemed to be less likely to go bankrupt. So an investor can decide to buy a stock if the Altman Z score is closer to value 3, and similarly, they can decide to sell a stock if the value is closer to 1.8.
  • In 2007, the specific asset-related securities had been given higher credit ratings than they must have been. However, the companies were correctly predicted to be increasing their financial riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more and should have been heading for bankruptcy. Altman calculated that the median Altman Z score of firms in 2007 was 1.81. These companies’ credit ratings were the same as that of the financial ratio B, which is used in the formula of Z above. It indicated that almost half of the companies are being rated lower, and they were extremely distressed and had a high likelihood of reaching a stage of bankruptcy.
  • Therefore, Altman’s Z Score calculations led him to believe that a crisis would occur, and there would be a meltdown in the credit market. Altman believed that the crisis would stem from company defaults. However, the meltdown began with mortgage-backed securities (MBS). Still, firms shortly defaulted in 2009 at the second-highest rate in history, as predicted by Altman’s model.

Altman Z score for private firms:

The original formula is modified to fit in case of private firms, and the business ratios used in case of this are:

Financial ratio usedThe formula for the financial ratio
A( Current Assets − Current Liabilities )/Total Assets
BRetained Earnings/Total Assets
CEarnings Before Interest and Taxes/Total Assets
DBook Value of Equity/Total Liabilities
ESales/Total Assets

The actual Altman Z Score formula for this model for determining the probability for a firm to close bankruptcy is:

Z’ = (0.717 x A) + (0.847 x B) + (3.107 x C) + (0.420 x D) + (0.998 x E)

  • In this model, if the Z value is greater than 2.99, then the firm is said to be in the “safe zone” and has a negligible probability of filing bankruptcy.
  • If the Z value is between 2.99 and 1.23, then the firm is said to be in the “grey zone” and has a moderate chance of bankruptcy.
  • And finally, if the Z value is below 1.23, then it is said to be in “distress zone” and has a very high probability of reaching the stage of bankruptcy.

Altman Z score for non-manufacturing firms (Developed and Emerging Markets)

The original formula is slightly modified to be used in the case of firms that are non-manufacturing and operating in the emerging markets. We use only four financial ratios in this model. The four ratios are as follows:

Business ratios usedThe formula for the business ratio
A( Current AssetsCurrent LiabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.read more ) /  Total Assets
BRetained Earnings / Total Assets
CEarnings Before Interest and TaxesEarnings Before Interest And TaxesEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital.read more / Total Assets
DBook Value of Equity / Total Liabilities

The actual Altman Z Score formula for this model for determining the probability for a non-manufacturing firm, operating in developed markets, to file bankruptcy is as follows:

Z’’ = (6.56 x A) + (3.26 x B) + (6.72 x C) + (1.05 x D)

The actual formula Altman Z Score formula for this model for determining the probability for a non-manufacturing firm operating in emerging markets to file bankruptcy is as follows:

Z’’ = 3.25 + (6.56 x A) + (3.26 x B) + (6.72 x C) + (1.05 x D)

  • In this model, if the Z value is greater than 2.6, then the firm is said to be in the “safe zone” and has a negligible probability of filing a bankruptcy.
  • If the Z value is between 2.6 and 1.1, then the firm is said to be in the “grey zone” and has a moderate chance of bankruptcy.
  • If the Z value is below 1.1, then it is said to be in the “distress zone” and has a very high probability of reaching the stage of bankruptcy.

Conclusion

The Alman Z-Score is a widely used metric with wide applications. It is one of the several credit marking models already in use that combine quantifiable financial indicators with a small range of variables, which will help us to predict whether or not a firm will financially fail or go into a bankruptcy stage.

However, over the years since its introduction, the Z-Score has been improved to become one among the reliable predictors of bankruptcy, and many analysts nowadays use this method above any other because of its wide applications. In fact, once Altman reevaluated his strategies by examining eighty-six distressed firms from 1969 to 1975 and then 110 bankrupt firms from 1976 to 1995 and later 120 bankrupt firms from 1996 to 1999. The Z-Score had an accuracy level of between 82% – 94%, which was more than that achieved by any of the methodologies that existed.

However, the “garbage in, garbage out” motto applies here as well. Therefore, if a firm’s financials, or the input data, are misleading or incorrect, the Z-Score will go wrong and will not be helpful at all in our analysis and prediction of bankruptcy.

Altman Z Score Video

This article has been a guide to Altman Z Score and how it predicts bankruptcy. Here we see the Altman Z Score Formula for manufacturing and private companies & nonmanufacturing companies in developed and emerging markets. You may learn more about Investment Banking from the following articles –