2. • The Z-score formula for predicting bankruptcy
was published in 1968 by Edward I. Altman, who
was, at the time, an Assistant Professor of
Finance at New York University.
• The Z-Score Test lets you use statistical
techniques to predict the likelihood of
bankruptcy within the next two years.
• Dr. Altman's test was developed using 66
companies, The test achieved an accuracy rate
of 95%.
• The financial ratios come directly from a
company's financial statements.
3. Z score bankruptcy model:
Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5
T1 = Working Capital / Total Assets
T2 = Retained Earnings / Total Assets
T3 = Earnings Before Interest and Taxes / Total
Assets
T4 = Market Value of Equity / Total Liabilities
T5 = Sales/ Total Assets
5. Z-score estimated for private firms
T1 = (Current Assets − Current Liabilities) / Total Assets
T2 = Retained Earnings / Total Assets
T3 = Earnings Before Interest and Taxes / Total Assets
T4 = Book Value of Equity / Total Liabilities
T5 = Sales/ Total Assets
Z' Score Bankruptcy Model:
Z' = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5
Zones of Discrimination:
Z' > 2.9 -“Safe” Zone
1.23 < Z' < 2. 9 -“Grey” Zone
Z' < 1.23 -“Distress” Zone
6. Z-score estimated for non-manufacturer
industrials & emerging market credits
T1 = (Current Assets − Current Liabilities) / Total
Assets
T2 = Retained Earnings / Total Assets
T3 = Earnings Before Interest and Taxes / Total
Assets
T4 = Book Value of Equity / Total Liabilities
Z-Score bankruptcy model:
Z = 6.56T1 + 3.26T2 + 6.72T3 + 1.05T4
Zones of discriminations:
Z > 2.6 -“Safe” Zone
1.1 < Z < 2. 6 -“Grey” Zone
Z < 1.1 -“Distress” Zone
7. 3 Easy Steps to Calculate the Z-
score
Steps
1
2
3
8. 1
• To calculate a manufacturer's Z-score
from scratch, the first step is to identify the
seven items listed on the balance sheet
and income statement used in the
calculation:
9. 2
• Together, these seven figures are used to
create five financial ratios, each identified
by Altman as having the greatest
forecasting power as to a company's
financial strength:
10. - Ratio A, Working Capital / Total Assets, is a liquidity measure. Working
capital is comprised of cash and any other assets that can be turned into cash
on fairly short notice. The more working capital a firm has, the more cushion it
has to meet any bills coming due.
- Ratio B, Retained Earnings / Total Assets, is a measure of leverage. It tells
us whether the firm is paying for assets using profits or using debt. A high ratio
indicates that profits are being used to fund growth, while a low ratio indicates
that growth is being financed through increasing debt levels.
- Ratio C, EBIT / Total Assets, is a profitability measure also known as return
on assets (ROA). It measures the amount of operating income generated by
each dollar of assets.
- Ratio D, Market Cap / Total Liabilities, is a measure of the market's
confidence in the company as reflected in its stock price. If the ratio falls below
1.0, then the market is saying that the firm is worth less than what it owes, or in
other words, insolvent.
- Ratio E, Sales / Total Assets, is a measure of efficiency in that it describes
the amount of sales generated by each dollar of assets
11. 3
• The third and final step is to use these
ratios in the Z-score formula to create the
final value:
Z-score = 1.2*(A) + 1.4*(B) + 3.3*(C) +
0.6*(D) + 1.0*(E)
12. It should now be easier to see why the Z-score
is such a good measure of a firm's financial
health. A healthy firm
(A) maintains enough liquid assets to pay
whatever bills are due,
(B) funds its growth with profits,
(C) invests in assets that generate profits for its
owners,
(D) gets a vote of confidence from investors via
its share price, and
(E) converts its investments into revenues for
the company.
13. Altman Z-Score Calculation
Balance Sheet Items:
Current Assets 3000
Current Liabilities 6000
Total Liabilities 4000
Total Assets 4000
Retained Earnings 2000
Market Value of Equity 5000
Income Statement Items:
EBIT 1000
Sales 2000
T1 (Working Capital/Total Assets) -0.75
T2 (Retained Earning/Total Assets) 0.5
T3 (EBIT/Total Assets) 0.25
T4 (Market Value of Equity/Total Liabilities) 1.25
T5 (Sales/Total Assets) 0.5
Altman Z-Score = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5 1.8745
