What is the Altman Z Score?

Altman Z score is a type of Z score, which Edward I. Altman published in 1968 as a Z score formulaZ Score FormulaThe Z-score of raw data refers to the score generated by measuring how many standard deviations above or below the population mean the data, which helps test the hypothesis under consideration. In other words, it is the distance of a data point from the population mean that is expressed as a multiple of the standard deviation.read more, used to predict the chances of bankruptcy. This methodology can predict the chance of a business organization to move into bankruptcy within a given time, which is mostly about two years.

This method successfully predicts the status of financial distressFinancial DistressFinancial Distress is a situation in which an organization or any individual is not capable enough to honor its financial obligations as a result of insufficient revenue. It is usually the result of high fixed costs, obsolete technology, high debt, improper planning and budgeting, and poor management, and it can eventually lead to insolvency or bankruptcy.read more in any firm. In addition, the Altman Z score can help measure a business organization’s financial health by using multiple balance balance sheet values Balance Sheet ValuesA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more and corporate income.

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Altman Z Score Formula

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:

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.

Application of Altman Z Score in predicting bankruptcy

  • The value of the Altman Z score is generally around – 0.25 for firms that have the highest probability of going bankrupt. On the other hand, for firms with the least 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, the firms with the 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 value 3, and similarly, they can decide to 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 riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more 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 extremely 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 there would be 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.

Altman Z score for private firms:

The original formula is modified to fit in case of private firms, and the business ratios used in case of this are:

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.

Altman Z score for 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 ratiosFinancial RatiosFinancial ratios are indications of a company’s financial performance. There are several forms of financial ratios that indicate the company’s results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more in this model. The four ratios are as follows:

The actual Altman Z Score formula for this model for determining the probability for a non manufacturing 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.

Conclusion

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, are misleading or incorrect, the Z-Score will go wrong and will not be helpful in our analysis and prediction of bankruptcy.

Altman Z Score Video

This article has been a guide to Altman Z Score and how it predicts bankruptcy. Here we see the Altman Z Score Formula for manufacturing and private companies & non-manufacturing companies in developed and emerging markets. You may learn more about Investment Banking from the following articles –

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