The Altman Z-Score is provided on numerous investment websites, but many people are unaware of how it’s calculated, let alone what scores are good or bad. This article explains how the Altman Z-Score is calculated, what the score means, and provides a complete example calculation using a real-world corporation. Investors tend to avoid companies with a low Altman Z-Score as they have a significantly higher predicted likelihood of filing for bankruptcy protection.
The Formula Explained
In 1968, Edward I. Altman, a professor of finance at New York University’s Stern School of Business, published his first paper developing what would become the Altman Z-Score. He followed that paper up, thirty-two years later, in 2000, with an updated version of the model. Over the years, Altman’s model has shown to be 80 to 90 percent reliable in predicting whether a manufacturing firm would need to file for bankruptcy protection with approximately 15 to 20 percent Type II Error.
The Altman Z-Score measures a company’s profitability by comparing its profitability against the profitability of its industry and its competitors. The Altman Z-Score uses two numbers, the ratio of earnings to sales and the ratio of return on assets to total assets. The Altman Z-Score is also called the Altman Ratio. The Altman Ratio measures the profitability of a company and compares it to the profitability of its industry. This score is used to identify companies that are undervalued relative to their industry.
-- Reliability indicates that the Altman Z-Score predicted bankruptcy, and the firm did declare bankruptcy, which occurred 80 to 90 percent of the time for manufacturing firms.
-- A Type II Error indicates the Altman Z-Score predicted bankruptcy when the firm did not go bankrupt, occurring in 15 to 20 percent of manufacturing firms analyzed.
Companies with Altman Z-Scores greater than 3 are likely safe from bankruptcy. Scores from 1.8 up to 3 are in the “gray zone” and are questionable regarding bankruptcy. Scores less than 1.8 predict a company that is likely to declare bankruptcy. Risk-averse investors would seek to only invest in companies with Altman Z-Scores greater than 3.