Author: |
Edward I. Altman (1968) | |

Used For: |
Predicting Bankruptcy; liquidity measurement ratios |

## Overview

The Z-Score Formula was devised by Edward Altman in 1968 to calculate the likeliness that a firm will enter bankruptcy within a period of two years. The formula uses common business ratios derived from income and balance sheets against weighted coefficients to measure the financial standing of the company.

The formula was originally used to calculate the financial health of public manufacturing firms but has been modified to include private manufacturing firms as well as non-manufacturing and service companies.

The Z-Score formula was developed by collecting sample data from 66 firms, half of which had filed for bankruptcy. Up until 1999 the Altman Z-Score was found to be approximately 80-90% accurate in forecasting bankruptcy with an approximately 15-20% type II error, i.e. categorizing a firm will go bankrupt when they actually don’t. There are now three versions of the Z-Score formula, specifically the Original Z-Score for public manufacturers, the Model A Z’-Score for private manufacturers and the Model B Z”-Score for private general firms. The models should not be interchanged and should only be applied to the firms that they have been devised for.

## The Basic Principles of the Altman Z-Score

The Z-Score formula uses five business ratios which vary slightly based on the type of firm that is being considered. All these ratios are easily calculated from the income and balance sheets.

Interpretation of the Z-Score result varies based on the type of firm that is being audited and can be categorized as a safe zone where bankruptcy is not likely, danger zone where bankruptcy is likely and a grey zone where bankruptcy is questionable. These are summarized as follows:

**Original Z-Score**(Probability of bankruptcy in the first year is 95% and second year 75%)- Greater than or equal to 3.00: “Safe Zone”
- Less than or equally to 1.80: “Danger Zone”
- Anything in between is considered to be a “Grey Zone”

**Model A Z’-Score**(Probability of bankruptcy in the first year is 95% and second year 70%)- Greater than or equal to 2.90: “Safe Zone”
- Less than or equally to 1.23: “Danger Zone”
- Anything in between is considered to be a “Grey Zone”

**Model B Z”-Score**(Probability of bankruptcy in the first year is 95% and second year 70%)- Greater than or equal to 2.60: “Safe Zone”
- Less than or equally to 1.10: “Danger Zone”
- Anything in between is considered to be a “Grey Zone”

## Challenges of Implementing the Z-Score in a Corporate Environment

Even though there is a margin of error in the Z-Formula it has been vastly accepted by auditors, accountants, loan evaluators and even courts in various countries. However anyone who implements the formula must keep in mind that the answer is not absolutely definitive.

The Altman Z-Score model is not recommended to gauge the bankruptcy position of financial institutions due to the regular use of off-balance sheet items and the transparency of their balance sheets.

## Other Readers Also Read: