Altman Z-Score Bankruptcy Prediction

Any single one of the 20 or so acknowledged financial ratios cannot adequately evaluate the overall
strength of a company, although each of them can be extremely useful in identifying specific
strengths and weaknesses that contribute to the general financial health of the firm.

The Z-Score Bankruptcy Predictor combines several of the most significant variables in a
statistically derived combination that was first published by Dr. Edward I. Altman in 1968 (See
The Journal of Finance, September, 1968.) It was originally developed on a sampling of
manufacturing firms. However, the algorithm has been consistently reported to have a 95 %
accuracy of prediction of bankruptcy up to two years prior to failure on non manufacturing firms
as well. There have been many other bankruptcy predictors developed and published. However,
none has been so thoroughly tested and broadly accepted as the Altman Z-Score. The Altman
Z-Score variables influencing the financial strength of a firm are:
Entry your financial data
CA = CURRENT ASSETS 1,356,551
TA = TOTAL ASSETS 3,020,121
SL = NET SALES 3,605,561
TL = TOTAL LIABILITY 1,186,296
CL = CURRENT LIABILITIES 486,296
VE = MARKET VALUE OF EQUITY 1,833,825
EBIT = EARNINGS BEFORE INTEREST AND TAXES 403,533
RE = RETAINED EARNINGS 283,825

THE ALTMAN Z-SCORE IS COMPUTED AS FOLLOWS:

Computing Factor 1
X1 = CA – CL divided by TA
X1 = $1,356,551 – $486,296 divided by $3,020,121
X1 = $870,255 divided by $3,020,121
X1 = .288
The least significant of factors, this is a measure of the net liquid assets of the firm in relation to
total assets. CA – CL is known as Working Capital.

Computing Factor 2
X2 = RE divided by TA
X2 = $283,825 divided by $3,020,121
X2 = .094
A more significant factor. A measure of profitability over time. The Retained Earnings Account
is subject to manipulation and a bias could be created. Earnings Account is subject to
manipulation and a bias could be created.

Computing Factor 4
X4 = VE divided by TL
X4 = $1,833,825 divided by $1,186,296
X4 = 1.546
More significant than the former. An indication of the firm's ability to suffer a decline in value of
assets. In closely held firms, VE may be substituted with (TA – TL). Users are cautioned that
this is a proxy that has not been statistically verified.

Computing Factor 5
X5 = SL divided by TA
X5 = $3,605,561 divided by $3,020,121
X5 = 1.194
Next to the most significant factor. It illustrates the sales generating ability of the firm's assets.

Computing Factor 3
X3 = EBIT divided by TA
X3 = $403,533 divided by $3,020,121
X3 = .134
The most important factor. Profit is the principal objective and is the force that eventually
determines the vitality of the firm. EBIT is Operating profit (gross profit less by operating
expenses-OPEX). Combining the above to provide a numerical value that can
indicate the strength of the firm we have:

Z = (1.2 x X1) + (1.4 x X2) + (0.6 x X4) + (1.0xX5*) + (3.3 x X3)

Z = (1.2 x 0.288) + (1.4 x 0.094) + (0.6 x 1.546) + (1.0 x 1.194*) + (3.3 x 0.134)
Z = (0.346) + (0.132) + (0.928) + (1.194*) + (0.442)
Z = 3.042

The Z-Score Bankruptcy Prediction calculated in this analysis is 3.042.

*Since Total Assets is the denominator of the X5 factor, small values here in relation to Sales can
provide a ratio of large numerical value. The user is cautioned that values in excess of 3 to 1 may
distort the predictor to provide an unwarranted favorable score. This may also be an indication that
the firm is undercapitalized in order to support the sales volume attained. The analyst may wish to
limit this ratio to 3 to 1, if inordinately high Z Scores are obtained on firms that otherwise indicate
softness. Since the Z Score model is based on manufacturing firms, the result may be more useful
as a trend indicator for other types of firms. But scores of less than 3.0 should be considered
cause for serious inquiry.

Other applications of the Z Score include use as one of the factors in the evaluation of the credit
worthiness of a firm and a factor in selecting firms for stock and bond investment.

When Z is 3.0 or more, the firm is most likely safe based on the financial data. Of course,
mismanagement, fraud, economic downturns, and other factors may cause an unexpected
reversal.

When Z is 2.7 to 3.0, the user is probably safe to predict survival, but this is a portion of the
gray area and is below the threshold of relative safety.
When Z is 1.8 to 2.7, the firm is likely to be bankrupt within two years. This is the lower portion
of the gray area and dramatic action may be required to effect survival.

When Z is Below 1.8, the firm is highly likely headed for bankruptcy. Rarely would a firm be
expected to recover from a financial condition generating this or lower scores.

Spreadsheet courtesy of MYC Academy academy@myconsulting.us