Since the pandemic began, I’ve noticed the Altman Z-Score has been attracting a lot of interest on Stockopedia. We have all become more focused on avoiding companies which may fall into financial distress, during this extremely difficult economic environment.
I studied for a Master’s Degree in Investment Analysis five years ago and my dissertation included a review of the academic literature on financial distress and failure prediction models. The most famous bankruptcy prediction model is of course, the Altman Z-Score. I thought I would share my findings here.
Some of the following sections may be a bit ‘academic’ in style - please forgive me for not re-writing the whole thing. I’ve included the original references to various academic articles as well, in brackets. If the articles prove difficult to obtain online and you really are interested, then I still have many of them stored on my hard drive, so feel free to send me a message asking for a copy.
Altman Z Score - Background & Limitations
First of all, please see this link for a previous article explaining the Altman Z-Score and this link for Stockopedia’s Z-Score short-screen page. These do a fine job explaining the model itself.
The seminal works on bankruptcy prediction came from Beaver in 1966 (124) and Altman in 1968 (125). Beaver’s univariate analysis was the first to show that financial ratios differed significantly between failed firms and non-failed firms. Altman expanded on Beaver’s work by developing a multivariate model. Altman’s Z-Score is still the most widely used and famous model despite several attempted alterations since its inception and many researchers criticising its underlying methodology (126).
Bankruptcy costs have long been considered in academic research as an important component of the debate around capital structure. A conventional (theoretical) view is that debt should be increased until the direct and indirect bankruptcy costs outweigh the associated tax benefits (112). Bankruptcy prediction models are an extremely popular area of research: one 2015 study identified 83 articles containing 137 different models (122). Most studies are based on US data and 95% focus on large PLCs (123).
Altman’s 1968 model is generally considered unsuitable for analysing contemporary British businesses (127, 128). In fact, the application of most US models to the UK is questionable, due to differences in accounting methods and insolvency codes between the two nations (129), and also…
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