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Altman Z Score

The Altman Z-score is a statistical model developed by Edward Altman in 1968 that uses multiple financial ratios to predict the probability that a firm will go bankrupt within two years. The original Z-score formula analyzed ratios related to liquidity, profitability, leverage, solvency, and asset management for publicly traded manufacturing firms. Later versions were developed to apply to private firms and non-manufacturing firms. The Z-score provides a score that indicates whether a company falls into the "safe", "grey", or "distress" zone that predicts bankruptcy risk.

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216 views19 pages

Altman Z Score

The Altman Z-score is a statistical model developed by Edward Altman in 1968 that uses multiple financial ratios to predict the probability that a firm will go bankrupt within two years. The original Z-score formula analyzed ratios related to liquidity, profitability, leverage, solvency, and asset management for publicly traded manufacturing firms. Later versions were developed to apply to private firms and non-manufacturing firms. The Z-score provides a score that indicates whether a company falls into the "safe", "grey", or "distress" zone that predicts bankruptcy risk.

Uploaded by

Shadab khan
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Altman Z-score

Example of an Excel spreadsheet that uses Altman Z-


score to predict the probability that a firm will go into
bankruptcy within two years
The Z-score formula for predicting
bankruptcy was published in 1968 by
Edward I. Altman, who was, at the time, an
Assistant Professor of Finance at New
York University. The formula may be used
to predict the probability that a firm will go
into bankruptcy within two years. Z-scores
are used to predict corporate defaults and
an easy-to-calculate control measure for
the financial distress status of companies
in academic studies. The Z-score uses
multiple corporate income and balance
sheet values to measure the financial
health of a company.

The formula
The Z-score is a linear combination of four
or five common business ratios, weighted
by coefficients. The coefficients were
estimated by identifying a set of firms
which had declared bankruptcy and then
collecting a matched sample of firms
which had survived, with matching by
industry and approximate size (assets).

Altman applied the statistical method of


discriminant analysis to a dataset of
publicly held manufacturers. The
estimation was originally based on data
from publicly held manufacturers, but has
since been re-estimated based on other
datasets for private manufacturing, non-
manufacturing and service companies.

The original data sample consisted of 66


firms, half of which had filed for
bankruptcy under Chapter 7. All
businesses in the database were
manufacturers, and small firms with
assets of < $1 million were eliminated.

The original Z-score formula was as


follows:[1]

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 +


1.0X5.
X1 = working capital / total assets.
Measures liquid assets in relation to the
size of the company.
X2 = retained earnings / total assets.
Measures profitability that reflects the
company's age and earning power.
X3 = earnings before interest and taxes /
total assets. Measures operating
efficiency apart from tax and leveraging
factors. It recognizes operating earnings
as being important to long-term viability.
X4 = market value of equity / book value
of total liabilities. Adds market
dimension that can show up security
price fluctuation as a possible red flag.
X5 = sales / total assets. Standard
measure for total asset turnover (varies
greatly from industry to industry).
Altman found that the ratio profile for the
bankrupt group fell at −0.25 avg, and for
the non-bankrupt group at +4.48 avg.

Precedents
Altman's work built upon research by
accounting researcher William Beaver and
others. In the 1930s and on, Mervyn and
others had collected matched samples
and assessed that various accounting
ratios appeared to be valuable in
predicting bankruptcy. Altman's Z-score is
a customized version of the discriminant
analysis technique of R. A. Fisher (1936).
William Beaver's work, published in 1966
and 1968, was the first to apply a
statistical method, t-tests to predict
bankruptcy for a pair-matched sample of
firms. Beaver applied this method to
evaluate the importance of each of several
accounting ratios based on univariate
analysis, using each accounting ratio one
at a time. Altman's primary improvement
was to apply a statistical method,
discriminant analysis, which could take
into account multiple variables
simultaneously.

Accuracy and effectiveness


In its initial test, the Altman Z-Score was
found to be 72% accurate in predicting
bankruptcy two years before the event,
with a Type II error (false negatives) of 6%
(Altman, 1968). In a series of subsequent
tests covering three periods over the next
31 years (up until 1999), the model was
found to be approximately 80%–90%
accurate in predicting bankruptcy one year
before the event, with a Type II error
(classifying the firm as bankrupt when it
does not go bankrupt) of approximately
15%–20% (Altman, 2000).[2]

From about 1985 onwards, the Z-scores


gained wide acceptance by auditors,
management accountants, courts, and
database systems used for loan
evaluation (Eidleman). The formula's
approach has been used in a variety of
contexts and countries, although it was
designed originally for publicly held
manufacturing companies with assets of
more than $1 million. Later variations by
Altman were designed to be applicable to
privately held companies (the Altman Z'-
Score) and non-manufacturing companies
(the Altman Z"-Score).

Neither the Altman models nor other


balance sheet-based models are
recommended for use with financial
companies. This is because of the opacity
of financial companies' balance sheets
and their frequent use of off-balance sheet
items. There are market-based formulas
used to predict the default of financial
firms (such as the Merton Model), but
these have limited predictive value
because they rely on market data
(fluctuations of share and options prices
to imply fluctuations in asset values) to
predict a market event (default, i.e., the
decline in asset values below the value of
a firm's liabilities).[3]

Original z-score component


definitions variable
definition
NOTE: The symbol " / " means the same
thing as " ÷ ", representing division.

X1 = working capital / total assets


X2 = retained earnings / total assets
X3 = earnings before interest and taxes /
total assets
X4 = market value of equity / total
liabilities
X5 = sales / total assets

Z score bankruptcy model:

Z = 0.12X1 + 0.14X2 + 0.33X3 + 0.006X4


+ 0.999X5

Zones of discrimination:
Z > 2.99 – “Safe” Zone
1.81 < Z < 2.99 – “Grey” Zone
Z < 1.81 – “Distress” Zone

Z-score estimated for private


firms
NOTE: The symbol " / " means the same
thing as " ÷ ", representing division.

X1 = (current assets − current liabilities)


/ total assets
X2 = retained earnings / total assets
X3 = earnings before interest and taxes /
total assets
X4 = book value of equity / total
liabilities
X5 = sales / total assets

Z' Score bankruptcy model:

Z′ = 0.717X1 + 0.847X2 + 3.107X3 +


0.420X4 + 0.998X5

Zones of discrimination:

Z′ > 2.9 – “Safe” Zone


1.23 < Z′ < 2.9 – “Grey” Zone
Z′ < 1.23 – “Distress” Zone

Z-score estimated for non-


manufacturers & emerging
markets
NOTE: The symbol " / " means the same
thing as " ÷ ", representing division.
X1 = (current assets − current liabilities)
/ total assets
X2 = retained earnings / total assets
X3 = earnings before interest and taxes /
total assets
X4 = book value of equity / total
liabilities

Z-Score bankruptcy model:

Z = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4[4]

Z-Score bankruptcy model (emerging


markets):

Z = 3.25 + 6.56X1 + 3.26X2 + 6.72X3 +


1.05X4

Zones of discriminations:
Z > 2.6 – “Safe” Zone
1.1 < Z < 2.6 – “Grey” Zone
Z < 1.1 – “Distress” Zone

See also
Standard score
Z-test
Z-factor
Ohlson o-score

References
Altman, Edward I. (July 2000). "Predicting
Financial Distress of Companies" (PDF).
Stern.nyu.edu: 15–22.
Altman, Edward I. (September 1968).
"Financial Ratios, Discriminant Analysis
and the Prediction of Corporate
Bankruptcy". Journal of Finance: 189–209.
doi:10.1111/j.1540-6261.1968.tb00843.x .

Altman, Edward I. (May 2002). "Revisiting


Credit Scoring Models in a Basel II
Environment" (PDF). Prepared for "Credit
Rating: Methodologies, Rationale, and
Default Risk", London Risk Books 2002.

Eidleman, Gregory J. (1995-02-01). "Z-


Scores – A Guide to Failure Prediction" .
The CPA Journal Online.
Fisher, Ronald Aylmer (1936). "The Use of
Multiple Measurements in Taxonomic
Problems" . Annals of Eugenics. 7: 179.
doi:10.1111/j.1469-1809.1936.tb02137.x .

The Use of Credit Scoring Modules and the


Importance of a Credit Culture by Dr.
Edward I Altman, Stern School of
Business, New York University.

1. realequityresearch.dk/Documents/Z-
Score_Altman_1968.pdf
2. Predicting Financial Distress of
Companies: Revisiting the Z-SCORE and
ZETA Models
3. Predicting Financial Distress of
Companies:Revisiting the Z-SCORE and
ZETA Models
4.
http://people.stern.nyu.edu/ealtman/IRMC2
014ZMODELpaper1.pdf

Further reading
Caouette, John B; Edward I Altman, Paul
Narayanan (1998). Managing Credit Risk
– the Next Great Financial Challenge,
John Wiley & Sons: New York. ISBN 978-
0-471-11189-4
Mare, Davide; Moreira, Fernando; Rossi,
Roberto (2016). "Nonstationary Z-score
measures". European Journal of
Operational Research. forthcoming.
doi:10.1016/j.ejor.2016.12.001 .
SSRN 2688367 .

External links
Altman Z-Score Calculator

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title=Altman_Z-score&oldid=867769640"

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