[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 ratios1:
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
He then assigned weightings to them based on their predictive values to create his model:
Z Score Bankruptcy Model:Z = 1.2T1 + 1.4T2 + 3.3T3 + .6T4 + .999T5
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 $1,000,0002. 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.
1The components and weightings of Altman's model come from Wikipedia.
2Alloy Steel's total assets are approximately $7,030,000 and its net assets are $4,393,000.
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