How to Accurately Predict Bankruptcy | Understanding the Z-Score Model

James Leichter
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Introducing the Z-Score Bankruptcy Model

This famous and widely used model (or ratio) represents the important work of New York University’s Professor Edward I. Altman. Originally, Altman studied 33 public corporations that filed for bankruptcy and 33 control firms selected at random. Using a very sophisticated statistical technique referred to as multiple discriminate analyses (MDA), he discovered that bankruptcy could be predicted up to two full years in advance through ratio analysis.

Small-Business managers using this formula should keep in mind that Altman excluded corporations with assets less than one million dollars. Also, decision making based on the Z-Score factors is biased towards short term credit risk avoidance and may not be appropriate for companies needing to develop new products, services, or markets. Please note different industries may operate under conditions that make the Z-Score factor (the actual score) less clear. Depending on the industry, some organizations can operate effectively with low Z-Score factors that may otherwise cause problems for other industry groups. Managers need to consider this when evaluating their Z-Score performance.

Does the Altman Z-Score Work?

In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years prior to the event. In subsequent tests over 31 years up until 1999, the model was found to be 80-90% accurate in predicting bankruptcy one year prior to the event.

Model Limitations

Financial managers need to realize that there are important limitations to this financial model. As you will learn, net profit before taxes (NPBT) is one of the most important of all factors. If management or officers do not pay themselves annual compensation that is considered “typical” or “normal”, net profit may be over or understated. This will adversely affect your Z-Score analysis, as it does not consider NPBT. Full-time working business owners should be paid approximately 6% to 8% of sales or whatever they could reasonably earn working at a similar job doing similar work.

If management does not track inventory properly or does not perform bookkeeping functions properly and accurately, the Z-Score may be completely useless.

Management is cautioned of these limitations and strongly encouraged to carefully study the formula and consider what other factors may be improperly stated and therefore affect the Z-Score.

The Original Formula

Z = (0.717* X1) + (0.847* X2) + (3.107* X3) + (0.42* X4) + (0.998* X5)

Where

X1 = Working Capital / Total Assets. This measures liquid assets as a firm in trouble will usually experience shrinking liquidity.

X2 = Retained Earnings / Total Assets. This indicates the cumulative profitability of the firm, as shrinking profitability is a warning sign.

X3 = Earnings Before Interest and Taxes / Total Assets. This ratio shows how productive a company in generating earnings, relative to its size.

X4 = Market Value of Equity / Book Value of Total Liabilities. This offers a quick test of how far the company’s assets can decline before the firm becomes technically insolvent (i.e. its liabilities exceed its assets).

X4A = Net Worth / Total Liabilities. The purpose of this ratio is the same as X4 but is used when the market value of equity is not known. Most small privately held companies would not have access to an accurate number, so this is used as a conservative replacement.

X5 = Sales / Total Assets. Asset turnover is a measure of how effectively the firm uses its assets to generate sales.

Z = Overall Index. Compare this number to the Bankruptcy Probability Chart below.

Bankruptcy Probability Chart

The original Z-Score classifications are:

> 2.90 suggests good financial health.

1.23 to 2.90 is a gray area where bankruptcy cannot be predicted accurately.

< 1.23 suggests bankruptcy.

Newer Altman Z2 Bankruptcy Model

This is what is used in Total Office Manager.

The usefulness of the original Z score measure was limited by two of the ratios. The first ratio X4, is Market Value of Equity divided by Total Liabilities. If a firm is not publicly traded, the market value of its equity is difficult to determine. The other ratio is X5, or Sales divided by Total Assets (Asset Turnover). The original Z Score expects a value that is common to manufacturing. This ratio varies significantly by industry and is not a key ratio to the residential light commercial contracting industry.

To deal with this, there is a more general revised Z-score for non-manufacturing businesses called Z2. This ratio modifies X4 and removes X5. These changes make the ratio far more relative to the typical HVAC, Plumbing, and Electrical contractor that has a good mix of income categories.

The Z2 Formula is:

Z2 = (6.56*X1) + (3.26*X2) + (6.72*X3) + (1.05*X4A)

You will notice this formula places no value on the market value of equity (what the value of the company is on the open market). It shifts the emphasis to solvency and liquidity. To gain a high score, a company needs to have more cash and less debt.

Bankruptcy Probability Chart

The new Z2 Score classifications are:

> 2.99 suggests good financial health.

1.81 to 2.99 is a gray area where bankruptcy cannot be predicted accurately.

< 1.81 suggests bankruptcy.

Bankruptcy Probability Chart – Extended Version

We have expanded the chart to provide a wider range of information.

Z-Score > 4.50

A Z-Score >= 5.0 suggests that the company is in excellent financial condition and possibly over-capitalized. This company should have more than adequate cash, and other current assets, to meet its current obligations over the next twelve months. Bankruptcy or insolvency during the next two years is highly unlikely unless conditions worsen rapidly and significantly. An analysis of efficiency and profitability ratios, such as Return on Assets, should be made to verify that the company is not overfunded. It may be possible that the company is not utilizing its current assets in the most efficient way.

Z-Score = 4.01 to 4.50

A Z-Score >= 4.50 suggests that the company is in very good financial condition and well-capitalized. This company should have sufficient cash, and other current assets, to meet its current obligations over the next twelve to twenty-four months. Bankruptcy or insolvency for the next two years is unlikely unless conditions worsen rapidly and significantly.

Z-Score = 3.51 to 4.00

A Z-Score >= 4.00 suggests that the company is in good financial condition. This company should have sufficient cash, and other current assets, to meet its current obligations over the next twelve months. Bankruptcy or insolvency during the next two years is unlikely unless conditions worsen rapidly and significantly.

Z-Score = 3.00 to 3.50

A Z-Score >= 3.50 suggests that the company is in moderately good financial condition. Bankruptcy or insolvency during the next two years is not particularly likely unless conditions worsen rapidly and significantly. Careful and regular attention should be paid to this company’s financial matters and immediate action taken if financial indicators worsen.

Z-Score = 1.81 to 2.99

A Z-Score of 1.81 to 2.99 falls within the “ignorance zone” of the Z-Score model and the data is inconclusive. However, it may suggest that the company’s financial condition is not strong and may be unstable. Bankruptcy or insolvency during the next two years cannot be accurately predicted.

Further analysis is required. A careful study of all financial reports, data, and ratios should be made by qualified personnel and, if required, corrective action be taken immediately.

Z-Score = 1.7 to 1.80

CORRECTIVE ACTION REQUIRED. A Z-Score >= 1.7 suggests that the company’s financial condition is weak, and its future is in danger. The company is severely undercapitalized and needs additional current assets. Bankruptcy or insolvency during the next two years is very possible if corrective action is not taken immediately. Qualified personnel should make a careful study of relevant financial reports, data, and ratios.

Z-Score < = 1.69

INSOLVENCY WARNING: A Z-Score < 1.6 suggests that the company’s financial condition is very weak, and its future is in grave danger. The company is severely undercapitalized and needs additional current assets. Bankruptcy or insolvency during the next two years is highly likely if corrective action is not taken immediately. Qualified personnel should make a careful study of relevant financial reports, data, and ratios. A “turn-around” plan should be produced and implemented as soon as possible.

Sources

Corporate Bankruptcy in America, Edward I. Altman, John Wiley and Sons, Inc.

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