Altman Z Score Bankruptcy and Corporate Health Predictor In 1968, NYU Professor Edward Altman developed a statistical model designed to provide a basis for safer investment decisions and improved assessment of supplier and customer credit worthiness. Since that time, the Altman Z Score has become a popular method of analyzing a company’s health and determining the likelihood of its filing bankruptcy within 1 to 2 years.

The formula was originally based on data from 66 publicly held manufacturing companies. Half of these had filed Chapter 7 bankruptcy within the last two years and half were going concerns. All 66 companies had assets of more than $1 million.

Professor Altman has since developed two additional models. One for privately held manufacturing companies and another for non-manufacturing companies (sometimes called “General Use Companies”).

Accuracy of Altman Z Score Statistical Model

It should be understood that the Altman Z Score is not 100% accurate. However, it has proved to be one of the best statistical models for determining bankruptcy risk and corporate health. In its initial tests, the Z Score achieved 72% accuracy in predicting bankruptcy within two years. Subsequent testing found the Z Score to be 80-90% accurate in predicting bankruptcy within one year.

In general, a deteriorating Z Score signals trouble. However, some companies with extremely low historical Z Scores have managed to recover and become very successful organizations. An example: Priceline.com had a 2003 Z Score of 0.1, signaling a very high likelihood of failing. However, the company remained viable. In fact, 5 years later, its Z Score was at 3.1, which is very much in the healthy range.

Components of the Altman Z Score

The Z Score calculation is based entirely on numbers from the company’s financial reports. It utilizes seven pieces of data taken from the corporation’s balance sheet and income statement. Five ratios are then extrapolated from these data points.

The data points include:

Data Point	Where Found in Financials	Formula to Calculate
1. Earnings before Interest & Tax (EBIT)	Income Statement	Gross Earnings - Interest - Income Tax Expense
2. Total Assets	Balance Sheet (Total Assets)	Total Current Assets + Net Fixed Assets
3. Net Sales	Income Statement (Net Revenues or Sales)	(This number in the Financials reflects deduction of returns, allowances and discounts)
4. Market (or Book) Value of Equity	Book Value found on Balance Sheet (Stockholders Equity)	Total Market Value (public Cos.) or Book Value (private Cos.) of all shares of stock
5. Total Liabilities	Balance Sheet	Total Current Liabilities + Long Term Debt
6. Working Capital	Balance Sheet	Total Current Assets - Total Current Liabilities
7. Retained Earnings	Balance Sheet (Stockholders Equity)	(Portion of net income retained by the corporation rather than distributed to owners/shareholders)

The five ratios are:

Ratio	Description
X1 = Working Capital/Total Assets	Measures liquidity, a company’s ability to pay its short-term obligations. The lower the value the higher the chance of bankruptcy.
X2 = Retained Earnings/Total Assets	Measures age and leverage. A low ratio indicates that growth may not be sustainable as it is financed by debt.
X3 = EBIT/Total Assets Earnings Before Interest and Tax	A version of Return on Assets (ROA), measures productivity – the earning power of the company’s assets. An increasing ratio indicates the company is earning and increasing profit on each dollar of investment.
X4 = Market Value of Equity/Total Liabilities	Measures solvency – how much the company’s market value would decline before liabilities exceed assets. (Use the Book value for private firms.)
X5 = Net Sales/Total Assets	Measures how efficiently the company uses assets to generate sales. Low ratio reflects failure to grow market share.

Calculating the Z Score

To calculate the Z Score, the results of each of the above five ratios are multiplied by a set factor (i.e. a coefficient developed by Professor Altman). The results of this multiplication are then added together to determine the company’s Z Score. The higher the score, the healthier the company. It is a good idea to compare a company’s Z Scores over time to get a better idea as to how the company is doing.

For Publicly-Held Manufacturing Firms

Z = 1.23X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Healthy: =>2.99
Grey Zone: =1.81-2.99
Unhealthy: =<1.81

For Privately-Held Manufacturing Firms

Note, in the X4 ratio, replace the Market Value of Equity with the Book Value.

Z = .717X1 + .847X2 + 3.107X3 + .42X4 + .998X5

Healthy: = >2.99
Grey Zone: = 1.23-2.99
Unhealth: = <1.23

For Non-Manufacturing (General Use) Firms

Because the X5 ratio is believed to vary significantly from industry to industry, that ratio is left out of the Z Score calculation.

Z = 6.56X1 + 3.26X2 + 6.72X3 +1.05X4

Healthy: = >2.6
Grey Zone: = 1.10-2.60
Unhealthy: = <1.10

Where the Altman Z Score is Not Reliable

As previously stated, the Z Score is not a perfect predictor. For instance:

It will not pick up bankruptcies caused by factors other than those that show up on the Balance Sheet like unexpected business disruptions, for instance.
It is not immune to false accounting practices (think WorldCom).
It is not useful for new companies with little or no earnings.
It can change dramatically from quarter to quarter when one-time write-offs are recorded.
It is not appropriate for small firms with assets less than $1 million.
It should not be used when studying financial firms due to their frequent use of off the balance sheet items and financial opacity.

Value of the Altman Z Score

The Z Score does not predict exactly when a firm will file a formal declaration of bankruptcy. What it does do is measure corporate financial stress. It is important to remember, however, that Altman used a relatively small number of companies in the Z Score's development. And, that it is that same Z Score developed more than 40 years ago that is still being used today.

So far, however, the Altman Z Score has proven to be an important tool to help credit professionals analyze corporate health, the possibility of bankruptcy, and overall creditworthiness.

A good rule of thumb? Don’t rely solely on the Z Score. But do include it in your toolbox of helpful financial analysis models.

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