[R]eal world application of the Z-Score successfully predicted 72% of corporate bankruptcies two years prior to these companies filing for Chapter 7"

In creating the Z-Score model, Professor Altman studied an initial sample of 66 firms, half of which had gone bankrupt, and looked for the balance sheet and income statement ratios that had the most predictive value. Dr. Altman settled on these five ratios

^{1}:

T_{1}= Working Capital / Total Assets

T_{2}= Retained Earnings / Total Assets

T_{3}= Earnings Before Interest and Taxes / Total Assets

T_{4}= Market Value of Equity / Total Liabilities

T_{5}= Sales/ Total Assets

He then assigned weightings to them based on their predictive values to create his model:

Z Score Bankruptcy Model:Z = 1.2T

_{1}+ 1.4T_{2}+ 3.3T_{3}+ .6T_{4}+ .999T_{5}

Based on this model, a Z-score below 1.8 means bankruptcy is likely within two years; a Z-score between 1.8 and 2.99 is a gray area; and a Z-score above 2.99 means there is little likelihood of bankruptcy within the next two years.

There are several free Altman Z-Score calculators available online to facilitate the use of the model. There is also a fully-automated Altman Z-Score calculator (where you just need to enter a company's symbol and the calculator does the rest) at Shortscreen.com. I used the one at Ironwood Advisory's website to calculate an Altman Z-Score for Alloy Steel International (OTC BB: AYSI.OB). The calculator gave a Z-score of 4.89, and included this commentary:

Your Z score is in the high range. This company is in good financial health and is predicted to remain solvent for the next two years. Smaller firms should note that these models are based on data from firms with assets in excess of $1,000,000^{2}. If it is believed that asset size affects Z scores, then their use may not be appropriate.

The photo above of Professor Altman comes from the CFA Institute.

^{1}The components and weightings of Altman's model come from Wikipedia.

^{2}Alloy Steel's total assets are approximately $7,030,000 and its net assets are $4,393,000.

## 6 comments:

Does this mean that, of the companies that file for bankruptcy, looking back at the score two years earlier would have shown that this was likely for 72% of them, or does it mean that, at any given moment, of all the companies that have a low score, 72% of them will file in the next two years?

There's a difference I think, between the two scenarios, right? That would mean, for instance, that a company like Gaylord Entertainment Group (GET), which currently has a very low score, has a 72% chance of filing in the next two years (from a recenty Motley Fool article).

The 72% figure came from this article by Greg Eidleman in the February, 1995 issue of The CPA Journal, "Z Scores - a guide to failure prediction":

"The Z score has proven successful in the real world. It correctly predicted 72% of bankruptcies two years prior to the event."I'm not familiar with GET, but I would guess that, given the current state of the economy, and the current tightness of credit, a company scoring below 1.8 would have a higher than 72% chance of going bankrupt in the next two years. That's just my guess though. I don't know if there have been statistical studies drilling down to come up with failure rates during recessions/credit crunches, or whether there have been studies comparing the likelihood of bankruptcy for firms scoring below 1.8 (i.e., does the likelihood increase monotonically below 1.8, so that, for example, a company with a Z-score of 1.4 is, say, 80% likely to go bankrupt, and a company with a score of 1.2 is, say, 85% likely to go bankrupt in ten years, etc.?).

I should note that the Altman Z-Score model gets modified for non-manufacturing companies. For non-manufacturing companies, the fifth variable, the Sales/Total Assets ratio, gets dropped and the weightings of the first four variables are changed.

Very interesting Dave. Thanks for posting that. Rawnoc has a Z Score of -10

I was told that the Altman Z-score could only be calculated using full year financial results and could not be updated quarterly based on SEC 10-Q filings. Is this correct?

By full year are you referring to trailing four quarters' data or fiscal year data? I don't know why the Altman Z-Score model wouldn't work if you used the trailing four quarters for the income statement data and the most recent filing for the balance sheet data. That's what I've been doing.

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