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Using the Altman Z Score to Predict Bankruptcy

Using the Altman Z Score to Predict Bankruptcy

– Guest Post by Joe Helstrom, CPA

Bankruptcy Predication - a foretller

 

 

 


Background:
The Altman Z score for bankruptcy prediction was first published by Edward Altman, an Assistant Professor of Finance at New York University, in 1968. He was trying to find financial ratios that could distinguish between a healthy company and one that might be distressed and enter bankruptcy.
To accomplish his goal, he evaluated common financial ratios of approximately 66 companies, all with assets or more than $1M. Approximately half of the firms had a bankruptcy in their past while the other half did not. He then used a statistical technique called Multiple Discriminant Analysis to determine which ratios were most predictive of bankruptcy and the proportion of those ratios to use.
Upon testing, Altman’s model was found to be 80-90% accurate in predicting bankruptcy one year prior to the event. However, it is also inaccurate 15% – 20% of the time in predicting bankruptcy, predicting that a firm will go bankrupt when it doesn’t.
While the accuracy rate is not 100%, it is still very good. It is so good that the Altman model has gained wide acceptance among accountants, auditors and even the courts.
Altman’s original model was designed for publicly traded manufacturing firms with assets of greater than $1 million. However, he has subsequently created two additional models to be used for private manufacturing companies and private non-manufacturing companies.
Ratios
The Altman models use the following ratios:
 A. Working Capital/Total Assets
B. Retained Earnings/Total Assets

  C. Earnings Before Interest and Taxes/Total Assets
  D. Equity/Total Liabilities
  E. Sales/Total Assets
Note that for public manufacturing companies, Equity is defined as the market value of equity. For non-public manufacturing companies, Equity is simply book equity.
The proportions of each ratio change with each model.
Calculations
For a public manufacturing company, the Altman Z Score model is (note Equity is market value of equity):
Z Score = 1.2*A + 1.4*B + 3.3*C + 0.6*D + .999*E
Evaluation:
• A score of less than 1.81 has a high likelihood of bankruptcy
• A score of 1.81 – 2.99 is in the “Gray” area
• A score of greater than 2.99 is a safe company

For a private non-manufacturer, the Altman Z Score model is:
Z Score = 6.56*A + 3.26*B + 6.72*C + 1.05*D
Evaluation:
• A score of less than 1.1 has a high likelihood of bankruptcy
• A score of 1.1 – 2.6 is in the “Gray” area
• A score of greater than 2.6 is a safe company
Note that the private non-manufacturer model does not use Sales/Total Assets.
The original model was developed for manufacturers. The non-manufacturer model was intended to fit service companies. A continuing criticism is that the model does not work for financial institutions.

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