# Altman Z-Score

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Meaning of Altman Z-Score

The Altman Z-Score is an analytical representation created by Edward Altman in the 1960s which involves a combination of five distinctive financial ratios used for determining the odds of bankruptcy amongst companies. Most commonly, a lower score reflects higher odds of bankruptcy.

Formula for Z-Score

The Z-Score can be characterized as a linear combination of 4-5 common business ratios. These ratios are weighted by coefficients which are estimated by spotting a set of firms which had declared a bankruptcy. Thereafter, a matched sample of firms is collected for the surviving firms, with matching by industry and estimated assets. The formula for Z-Score and prediction of bankruptcy was given by Edward I. Altman in 1968. This formula for Altman Z-Score is helpful in calculating and predicting the probability that a company will go into bankruptcy within two years.

4-factor model of the Altman Z-score (for a private non-manufacturer):

Z-score = 6.56T1 + 3.26T2 + 6.72T3 + 1.05T4

where,

T1 = Working Capital / Total Assets
T2 = Retained Earnings / Total Assets
T3 = Earnings Before Interest and Taxes / Total Assets
T4 = Equity / Total Liabilities

Zones of Discrimination:

• 1.1 or less – “Distress” Zone
• from 1.1 to 2.6 – “Grey” Zone
• 2.6 or more – “Safe” Zone

5-factor model of the Altman Z-score (a for private manufacturing firms):

Z-score = 0.717T1 + 0.847T2 + 3.107T3 + 0.42T4 + 0.998T5

where,

T1 = Working Capital / Total Assets
T2 = Retained Earnings / Total Assets
T3 = Earnings Before Interest and Taxes / Total Assets
T4 = Equity / Total Liabilities
T5 = Sales / Total Assets

Zones of Discrimination:

• 1.23 or less – “Distress” Zone
• from 1.23 to 2.9 – “Grey” Zone
• 2.9 or more – “Safe” Zone

Interpretation of Altman Z-Score

The Z-Scores are helpful in predicting corporate defaults as well as an easy-to-calculate measure of control for financial distress status of companies in academic studies. A Z-Score above 2.6 (2.9) indicates a company to be healthy. Besides, such a company is also not likely to enter bankruptcy. However, Z-Scores ranging from 1.1-2.6 (1.23-2.9) are taken to lie in the grey area.

Altman’s Z-Score indicator can be easily calculated using ReadyRatios financial analysis software which also makes the conclusion on the result.

Accuracy and effectiveness

In the initial stages, the Altman Z-Score was found to be 72% exact in predicting bankruptcy two years preceding the event, including a Type II error (false positives) of 6%. However, the model was found to be about 80-90% accurate in the process of predicting bankruptcy one year preceding the event, in a series of ensuing tests including three distinctive time periods over the next 31 years. However, a type II error, classifying the company as bankrupt while it is not going so, of 15-20% was also included in these tests.

The approach of Altman’s Z-Score formula has achieved ample acceptance by management accountants, auditors, database systems, and courts used for loan evaluation. Besides the approach of this formula has been used in an assortment of countries and contexts, although it had been initially designed for publicly held manufacturing firms featuring assets of more than \$1 million.