Methods and concepts for Value Based Management (VBM)
The Z-Score formula for Predicting Bankruptcy of Edward Altman is a multivariate formula for a measurement of the financial health of a company and a powerful diagnostic tool that forecasts the probability of a company entering bankruptcy within a 2 year period. Studies measuring the effectiveness of the Z-Score have shown the model is often accurate in predicting bankruptcy (72%-80% reliability) The Z-Score was developed in 1968 by Dr. Edward I. Altman, Ph.D., a financial economist and professor at New York University's Stern School of Business.
The Z-Score bankruptcy predictor combines five common business ratios, using a weighting system calculated by Altman to determine the likelihood of a company going bankrupt. It was derived based on data from manufacturing firms, but has since proven to be effective as well (with some modifications) in determining the risk a service firm will go bankrupt.
How should the results be judged? It depends:
Original Z-SCORE [For Public Manufacturer]
If the score is 3.0 or above - bankruptcy is not likely. If the Score is 1.8 or less - bankruptcy is likely. A score between 1.8 and 3.0 is the gray area. Probabilities of bankruptcy within the above ranges are 95% for one year and 70% within two years. Obviously, a higher score is desirable.
Model A Z'-Score [For Private Manufacturer]
Model A of Altman's Z-Score is appropriate for a private manufacturing firm. Model A should not be applied to other companies. A score of 2.90 or above indicates that bankruptcy is not likely, but a score of 1.23 or below is a strong indicator that bankruptcy is likely. Probabilities of bankruptcy in the above ranges are 95% for one year and 70% within two years. Obviously, a higher score is desirable.
Model B Z'-Score [For Private General Firm]
Edward Altman developed this version of the Altman Z-Score to predict the likelihood of a privately owned non-manufacturing company going bankrupt within one or two years. Model B is appropriate for a private general (nonmanufacturing) firm. Model B should not be applied to other companies. A score of 1.10 or lower indicates that bankruptcy is likely, while a score of 2.60 or above can be an indicator that bankruptcy is not likely. A score between the two is the gray area. Probabilities of bankruptcy in the above ranges are 95% for one year and 70% within two years. Again, obviously, a higher score is desirable. For the Z-Score Formula, see the figure on the right.
Note the variations for public and private companies.