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 of 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.
The Actual Formula *
Z = (0.717* X1) + (0.847* X2) + (3.107* X3) + (0.42* X4) + (0.998* X5)
X1 = Working Capital /Total Assets
X2 = Retained Earnings / Total Assets
X3 = NPBT /Total Assets
X4 = Total Equity /Total Liabilities
X5 = Sales /Total Assets
Z = Overall index
The original Z-Score classifications are < 1.23 suggests bankruptcy, > 2.90 suggests good financial health, and 1.23 to 2.90 is a gray area where bankruptcy cannot be predicted accurately.