Altman Z Score

Updated on May 8, 2024
Article byMilan Jha
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Altman Z Score?

Altman Z score is a type of score, which Edward I. Altman published in 1968 as a Z score formula, used to predict the chances of bankruptcy. This methodology can predict a business organization’s opportunity to enter bankruptcy within a given time, mainly two years.

Altman Z Score Definition

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This method successfully predicts the status of financial distress in any firm. The calculation considers the risk, profitability, liquidity, and activity ratios while computing the score. In addition, the Altman Z score can help measure a business organization’s financial health by using multiple balance balance sheet values and corporate income.

Key Takeaways

  • Altman Z score is a z score that can determine the chances of bankruptcy. This score can determine if and when a company will move to bankruptcy within a stipulated time (mostly two years).
  • The Altman Z Score formula is (1.2 x A) + (1.4 x B) + (3.3 x C) + (0.6 x D) + (0.999 x E)
  • Here, A is working capital / total assets, B is retained earnings / total assets, C is earnings before interest and task payment / total assets, D is equity market value / total assets, and E is total sales / total assets.
  • The value of the Altman Z score is typically around -0.25 for businesses with the highest bankruptcy risk. Conversely, the Altman Z score value might reach +4.48 for businesses with the lowest likelihood of insolvency.

Altman Z Score Explained

The altman z score model is a method to calculate and forecast the possibility of a business going bankrupt, through use of ratio related tp liquidity, profitability, solvency, activity, etc.

The Altman 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 predict whether a firm will financially fail or go into a bankruptcy stage.

However, over the years since its introduction, the Z-Score has improved to become one of the reliable predictors of bankruptcy. Many analysts nowadays use this method because of its wide applications. For example, 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 120 bankrupt firms from 1996 to 1999. The Z-Score had an accuracy level of 82% – 94%, which was more than that achieved by any of the methodologies.

However, the “garbage in, garbage out” motto applies here. Therefore, if a firm’s financials, or the input data, need to be more accurate or correct, the Altman z score model will go wrong and will not be helpful in our analysis and prediction of bankruptcy.

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Altman Z Score Explained in Video

Formula

The formula used to calculate Altman z score is given below.

Altman Z Score Equation

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Examples

Let us understand the concept with some examples.

Publicly Held Manufacturing Firms

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

The five 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, 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 in the “gray zone” and has a moderate probability of 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.

Private firms

  • The original formula calculate Altman z score 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, 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 in the “gray zone” and has a moderate chance of bankruptcy.
  • And finally, if the Z value is below 1.23, it is said to be in the “distress zone” and has a very high probability of reaching the stage of bankruptcy.

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 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
ACurrent Assets − Current Liabilities /  Total Assets
BRetained Earnings / Total Assets
CEarnings Before Interest and Taxes / Total Assets
DBook Value of Equity / Total Liabilities

The actual Altman z score analysis formula for this model for determining the probability for a nonmanufacturing 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, 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 in the “gray 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.

Interpretation

  • The Altman z score analysis value is generally around – 0.25 for firms with the highest probability of going bankrupt. On the other hand, for firms with the most negligible probability of bankruptcy, 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 selling 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, firms with an Altman Z score above three are less likely to go bankrupt. So an investor can decide to buy a stock if the Altman Z score is closer to a value of 3, and similarly, they can 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 risk 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 Z formula above. It indicated that almost half of the companies are being rated lower, and they were highly 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 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.

Advantages

  1. It helps in decision making and analysis.
  2. It helps to assess the credit worthiness and solvency of a business.
  3. It is very useful in the stock market for analysis. It helps investors to decide whether to buy a stock or not.

Disadvantages

  1. The calculation of the model is dependent on the samples. Therefore, such instances may only sometimes give clear and precise data, thus doubting the Altman z score accuracy.
  2. Continuous change in the business and financial world is exposing companies to various forms of risk from time to time, affecting profits. Thus, in such circumstances, prediction based on past data will not yield the correct result.
  3. Altman z score accuracy is also doubtful because is unable to predict when the business may actually become bankrupt.

Frequently Asked Questions (FAQs)

What is the formula for the Altman Z score?

The Altman Z Score formula is (1.2 x A) + (1.4 x B) + (3.3 x C) + (0.6 x D) + (0.999 x E). Here, A is working capital / total assets, B is retained earnings / total assets, C is earnings before interest and task payment / total assets, D is equity market value / total assets, and E is total sales / total assets.

How is the Altman Z score evaluated?

The Altman Z score determines the chances of bankruptcy for a company. The Altman Z score for companies with the highest bankruptcy risk is typically around -0.25. On the other hand, for companies with the lowest chance of bankruptcy, the Altman Z score value may rise to +4.48.

What is the formula of Altman Z score for private companies?

The formula for the Altman Z score for private companies is Z’ = (0.717 x A) + (0.847 x B) + (3.107 x C) + (0.420 x D) + (0.998 x E). Here, A is (current assets − current liabilities )/total assets, B is retained earnings / total assets, C is earnings before interest and taxes / total assets, E is the book value of equity / total liabilities, and E is sales / total assets.

This article has been a guide to what is Altman Z Score. We explain it with formula, its interpretation along with example, advantages and disadvantages. You may learn more about Investment Banking from the following articles –