Named after its inventor Edward I. Altman, the Z-score model for predicting bankruptcy (also referred as a model for financial distress prediction, or simply bankruptcy test) is a special model, applying which the analyst would be able to predict firm’s bankruptcy within a period of two years. It is often used for company’s default possibility measurement and for estimating its financial distress status.
The elements of the Altman Z-score formula computation are five business ratios, which are commonly used during the financial statement analysis performance. They are being marked as X1, X2, X3, X4 and X5. Z-score is a result of these ratios being weighted by coefficients and summed up. The coefficients were developed after application of the analysis to some firms, which have declared becoming bankrupts.
The formula for Z-Score computation looks as follows:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.1X5
Let’s have a closer look at its components:
X1 = Working Capital ÷ Total Assets. The working capital to total assets is a ratio, which is usually being computed as a part of the firm’s liquidity ratio analysis. The ratio should only be compared between similar-sized companies, working in the same industry. There is no recommended value for this ratio, however, negative working capital to total assets ratio would indicate problems with paying short-term debts.
X2 = Retained Earnings ÷ Total Assets. This is the ratio of two elements of the balance sheet of a firm, indicating firm’s profitability and leverage. It measures the part of assets, which has been financed by the retention of earnings instead of short-term and long-term debts.
X3 = Earnings Before Interest and Taxes ÷ Total Assets. Also referred as return on total assets, this is a key ratio in Altman formula, and it reflects the efficiency of company’s assets usage in order to generate earnings before paying the contract obligations and taxes.
X4 = Market Value of Equity ÷ Book Value of Total Debt. This ratio measures the possible decline in value of firm’s assets before its insolvency in case the liabilities exceed assets.
X5 = Sales ÷ Total Assets. This is a commonly used ratio during the activity analysis of a firm, called total asset turnover. It measures the ability of a firm to generate sales through its assets.
Z-score is a value, received after summing up all the variables from the equation.
Having computed the Z-score for a firm, the analyst can make a conclusion on its bankruptcy risks, based on the value calculated. There are special zones for Z-score values, depending on which the financial distress risk may either be high, or low:
- Z-score higher than 2.99 is considered to be in a safe zone;
- Z-score between 1.81 and 2.99 is considered to be in a grey zone;
- Z-score lower than 1.81 is considered to be in a distress zone.
Altman Z-score financial distress prediction model is a useful tool of company’s financial health estimation. Based on common financial ratios this formula is a fast way to predict either the possible bankruptcy of a firm, or to confirm its stable financial position.