The Altman Z-Score: Is it possible to predict corporate bankruptcy using a formula?

Wednesday, Apr 13 2011 by
12
Developed in 1968 the Altman ZScore seeks to estimate corporate bankruptcy risk
Developed in 1968, the Altman Z-Score seeks to estimate corporate bankruptcy risk

In Brief

The Altman Z-score is a combination of five weighted business ratios that is used to estimate the likelihood of financial distress. If the credit crunch itself wasn’t lesson enough, respected fund manager Anthony Bolton has emphasised the importance of understanding credit risk when investing in equities: “When I analysed the stocks that have lost me the most money, about two-thirds of the time it was due to weak balance sheets. You have to have your eyes open to the fact that if you are buying a company with a weak balance sheet and something changes, then that’s when you are going to be most exposed as a shareholder.”

Background to the Z-Score

The Z-Score was developed in 1968 by Edward I. Altman, an Assistant Professor of Finance at New York University, as a quantitative balance-sheet method of determining a company’s financial health. A Z-score can be calculated for all non-financial companies and the lower the score, the greater the risk of the company falling into financial distress. 

The original research was based on data from publicly held manufacturers (66 firms, half of which had filed for bankruptcy). Altman calculated 22 common financial ratios for all of them and then used multiple discriminant analysis to choose a small number of those ratios that could best distinguish between a bankrupt firm and a healthy one. To test the model, Altman then calculated the Z Scores for new groups of bankrupt and nonbankrupt but sick firms (i.e. with reported deficits) in order to discover how well the Z Score model could distinguish between sick firms and the terminally ill. 

The results indicated that, if the Altman Z-Score is close to or below 3, it is wise to do some serious due diligence before considering investing. The Z-score results usually have the following "Zones" of interpretation:

  1. Z Score above 2.99 -“Safe” Zones. The company is considered ‘Safe’ based on the financial figures only.
  2. 1.8 < Z < 2.99 -“Grey” Zones. There is a good chance of the company going bankrupt within the next 2 years of operations.
  3. Z below 1.80 -“Distress” Zones. The score indicates a high probability of distress within this time period.

The Z-score has subsequently been re-estimated based on other datasets for private manufacturing companies, as well as non-manufacturing / service companies.

Does the Altman Z-Score Work?

In its initial test, the…

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4 Comments on this Article show/hide all

dangersimpson 29th Oct '12 1 of 4
3

Dave,

I've noticed that a number of companies seem to score low on the Altman z-score when the have negative working capital. The reason is T1 = Working Capital / Total Assets will be negative and therefore significantly reduce the z-score.

This seems to make companies that seem pretty safe to me - e.g. Cineworld (LON:CINE) as high bankruptcy risk simply because they tend to collect the money from consumers significantly before they pay suppliers and hence have negative working capital. Personally I really like businesses like this because they don't raise equity capital from me or bank debt that could be pulled to finance their working capital and I struggle to see how this massively increases their financial risk profile unless their negative WC was because they are refusing to pay suppliers on time.

Not read Altman's book so does he cover companies with negative WC. Intuitively it would seem to make more sense to use the absolute values of WC & Net Assets so:

T1 = |Working Capital| / |Total Assets|

Or am I missing something obvious here?

Cheers,

Danger

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Murakami 29th Oct '12 2 of 4
2

In reply to dangersimpson, post #1

Hi DM, thanks for a great comment. As I'm sure you know, negative working capital means that current liabilities exceed current assets. The reason it's used in the Altman calculation is that this fact is a strong indicator that the company could be in serious financial trouble. As you say, this is ambiguous though, as it can also be a sign of managerial or business efficiency - for example, it might be a business with low inventory and accounts receivable (which means they operate on effectively a cash basis).

Altman generally works well, in aggregate, but no statistical indicator will ever get it right 100% of the time. Financials is one known limitation and, although there is a more generic Z2 score, the original Z-Score was originally designed for "industrial companies" which typically don't have the kind of financial profile you describe. That's why we provide the popups for the Piotroski, Altman & Beneish "red flags" so users can look into specific company factors that might lead someone to draw a different conclusion.

We are not aware of any reliable adjustment factor that has been applied to weed out "good" negative working capital companies but we'll look into this further. We're also planning to implement the Distance to Default, which will be another bankruptcy risk indicator to use alongside the Altman score.

p.s. This short-selling screen is an illustration of how well it works at a portfolio level, though, notwithstanding these limitations, although its performance on the downside is eclipsed by this one

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Murakami 29th Oct '12 3 of 4
1

It's also interesting to note this blog which - in discussing this very issue - argues that an alternative, fairly obvious way of screening for solvency risk is by looking for companies that show:

1. High operating risk: The top two deciles of standard deviation of EBIT or EBITDA margin over the last 5 or 10 years (pick your horizon)
2. High financial leverage: The top two deciles of financial leverage, by total debt to market equity or interest coverage. Normalized decile scores by sector.

We're actually working on an Earnings Variability indicator so we'll look at adding that too as a tracked screen to see how it compares.

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Murakami 29th Oct '12 4 of 4
1

p.s. We've also added a summary article on these points to the Help & FAQ section - thank for raising it: 

http://help.stockopedia.co.uk/knowledgebase/articles/132951-what-are-the-known-limitations-of-the-altman-z-sco

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