Introduced in 1968, Altman Z-score is still used to predict the bankruptcy of a company within a 2-year period. It is also used to predict corporate defaults and control the financial distress status of companies. The Z-score formula uses such ratios as working capital, total assets, retained earnings, etc.
What Is Altman Z-score?
It is a mathematical formula for evaluating the risk of enterprise bankruptcy, which was first introduced by American economist Edward Altman in 1968.
For the first time, the score for companies that list their shares on the stock exchange was published in Altman's study "Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy" in 1968. The 1968 model included data on the financial state of 66 enterprises, half of which went bankrupt, and the other half continued to operate successfully. In 1983, in his article "Corporate Financial Distress", Altman published a model for enterprises whose shares are not listed on the stock exchange.
In 1993, in his book "Corporate Financial Distress and Bankruptcy", the economist presented a model for non-production companies. In 2003, Altman published the article "Managing Credit Risk: a Challenge for the New Millennium", where he introduced a Z-score for emerging markets. In 2007, E. Altman and D. Sabato presented a logit model based on a sample of 120 bankrupts and 2010 non-bankrupts in their article "Modeling Credit Risk for SMEs: Evidence from the US Market Data".
Altman Z-score is a function of indicators characterizing the economic potential of an enterprise and the results of its work over the past period. In the initial study, 66 industrial enterprises were analyzed, half of which went bankrupt during 1946-1965, and half worked successfully. The author investigated 22 analytical factors that could be useful for predicting possible bankruptcy. From these factors, he selected 5 most significant ones and constructed a multifactorial regression equation. There is also a simplified two-factor model, an advanced 7-factor model, a four-factor score for non-production enterprises, and others.
The two-factor model uses only two indicators: the current liquidity ratio and the share of borrowed funds in liabilities. The standard five-factor model considers the working and retained capital, earnings before interest and taxes, and sales - all of these divided by total assets - as well as the market value of equity divided by the book value of total liabilities.
There is also a modified variant of the five-factor score for private companies that do not trade their shares on a stock market. Instead of the fourth factor of the standard Z-score, this model uses the "carrying value of equity / borrowed capital" factor.
The advanced 7-factor model, which can forecast bankruptcy for the next 5 years with the accuracy up to 70%, includes these factors:
X1: return on assets (profit (loss) before tax/total assets),
X2: profit variability (reporting year profit/base year profit),
X3: interest coverage (profit before tax and interest on loans/loans percentage),
X4: cumulative profitability (balance sheet profit/total assets),
X5: current liquidity (working capital in stocks and other assets/most urgent liabilities),
X6: autonomy (sources of equity/total assets (liabilities)),
X7: total assets turnover (annual revenue for products sold/total assets).
The four-factor Z-score for non-production enterprises uses the first three factors from the standard model supplemented with the "equity/debt capital" factor.