The Z-Score for predicting bankruptcy was published in 1968 by Edward I. Altman, who was assistant professor of finance at New York University at that time. It measures the financial health of a company based on a set of income and balance sheet values. The Altman Z-Score predicts the probability that a firm will go bankrupt within 2 years. In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years before the event. In a series of subsequent tests, the model was found to be approximately 80%–90% accurate in predicting bankruptcy one year before the event
Atman built the model by applying the statistical method of discriminant analysis to a dataset of publicly held manufacturers. Since then he has published new versions based on other datasets for private manufacturing (Z'-Score), non-manufacturing, service companies and companies in emerging markets. (Z''-Score)
Please also note that the original dataset used was quite small and consisted of only 66 firms of which half filed for bankruptcy. All companies were manufacturers and small firms (total assets < $1m) were removed.
We currently support the original model so please take care to only use it to assess manufacturers.
How is it calculated?
The Z-score is calculated as follows:
The 5 components used in the calculation are:
X1, Working Capital/Total Assets (WC/TA)
"The working capital/total assets ratio...is a measure of the net liquid assets of the firm relative to the total capitalization...A firm experiencing consistent operating losses will have shrinking current assets in relation to total assets. "
X2, Retained Earnings/Total Assets (RE/TA)
"Retained earnings is the account which reports the total amount of reinvested earnings and/or losses of a firm over its entire life... This ratio discriminates young companies on purpose as the incidence of failure is much higher in a firm’s earlier years... It also measures the leverage of a firm. Those firms with high RE, relative to TA, have financed their assets through retention of profits and have not utilized as much debt."
X3, Earnings Before Interest and Taxes/Total Assets (EBIT/TA)
"This ratio is a measure of the true productivity of the firm’s assets, independent of any tax or leverage factors... insolvency in a bankrupt sense occurs when the total liabilities exceed a fair valuation of the firm’s assets with value determined by the earning power of the assets."
X4, Market Value of Equity/Book Value of Total Liabilities (MVE/TL)
"The measure shows how much the firm's assets can decline in value (measured by market value of equity plus debt) before the liabilities exceed the assets and the firm becomes insolvent. "
X5, Sales/Total Assets (S/TA)
"The capital-turnover ratio is a standard financial ratio illustrating the sales generating ability of the firm’s assets. It is one measure of management’s capacity in dealing with competitive conditions. "
Source of the quotes above: Edward I. Altman - Predicting Financial distress of companies: revisiting the Z-Score and Zeta models.