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This
article introduces this valuable predictor of financial distress, and offers a calculation spreadsheet.
The Altman Z-Score was published in 1968 by Edward Altman, and measures a company’s financial
heatlth. He chose 66 publicly-traded manufacturing companies (half of which had declared
bankruptcy, and half of which had not). Altman then examined several common financial ratios based
on data retrieved from annual financial reports. After linearly combining these ratios, Altman arrived
at an empirical equation (called the the Z-Score) that predicted the risk of corporate failure within
two years with an accuracy of 72%, and false-positives at 6%
This equation was also tested against companies not in the initial sample. The equation predicted
bankruptcy or non-bankruptcy to within a high degree of accuracy.
Altman later published modification called the Z1-Score, which can be applied to privately-held
manufacturing companies, and Z2-score for non-manufacturing companies.
The value of the Z-Score indicates the health of a
company, with a higher value being better. The equations use the following financial information.
Working Capital
Total Assets
Retained Earnings
Earnings Before Tax and Interest, or EBIT
Market Value of Equity (for publicly-traded companies
Book Value or Net Worth (for privately-end companies)
Total Liabilities
Sales
These quantities are combined into the follows ratios
These equations are implemented in a spreadsheet available at the bottom of this article
The Z-Score is still widely used primarily because of its simplicity and the ease with which the
financial data is obtained. However, Shumway (2001) demonstrated than several of the parameters
use in the Z-score equations now do not adequately predict bankruptcy, and identified a better
predictive model. Chava and Jarrow (2004) confirmed that the Shumway (2001) model is a better
predictor of financial distress.