Predicting Bankruptcy

One of the most useful tools for predicting whether or not a publically-traded company might be headed for bankruptcy is the Altman Z-Score. The main advantage of the Altman Z-score is that it takes information easily found in a company's financial statements and uses a simple formula to compute a numeric value that may be used to assess its degree of financial distress.

Originally developed in 1968, the Z-Score was created by Edward Altman of New York University's Stern School of Business, who updated his original work in 2000. This updated work forms the basis for the tool presented below.

The tool below may be used to compute the Altman Z-Score for a publically-traded company found in Manufacturing or in non-financial Non-Manufacturing industries. The necessary financial data for a company of interest may be found using Yahoo! Finance or Google Finance. The default data is taken from General Motors' financial statements for the 3 months ending March 31, 2006.

Income Statement Data
Input Data	Values
Net Sales (Gross Profit)
Earnings Before Interest and Taxes (EBIT)
Balance Statement Data
Total Current Assets
Total Assets
Total Current Liabilities
Total Liabilities
Retained Earnings
Market Value of Equity (Total Stockholder Equity)
Type of Company
Manufacturing or Non-Manufacturing?	Manufacturing Non-Manufacturing

Calculated Financial Ratios
Calculated Results	Values
Return on Total Assets Ratio
Net Sales to Total Assets (Asset Turnover) Ratio
Equity to Debt Ratio
Working Capital to Total Assets Ratio
Retained Earnings to Total Assets Ratio
Altman Z-Score
Altman Z-Score

Is the Company Healthy?

The following table indicates the degree to which a company may be in distress according to its industry:

Z-Score Indication of Financial Distress
Financial Health	Manufacturing	Non-Manufacturing
Good	Z-Score > 2.67	Z-Score > 2.60
Neutral	1.81 < Z-Score < 2.67	1.10 < Z-Score < 2.60
Danger!	Z-Score < 1.81	Z-Score < 1.10

Altman identifies a zone of ignorance for Z-Scores between the Danger threshold cut-off and a Z-Score of 2.99. As a result, a company with a Z-Score greater than 2.99 may be considered "sound." By contrast, a company with a score below the Danger threshold is a likely candidate for bankruptcy or potential default on its outstanding bonds.

For investors, a Z-Score that falls in Altman's "Ignorance Zone" shouldn't necessarily be excluded from consideration, but a score in this range does indicate there may be a need to more closely investigate a particular company's situation. Investors may also find it beneficial to determine a company's Z-Score going back over several investing periods in order to establish if a trend exists.

How Accurate Are the Predictions?

For manufacturing companies that scored 2.67 or less, the Altman-Z score has a surprising level of accuracy in being able to predict a future bankruptcy or default on the distressed companies' outstanding bonds. Between 1969 and 1999, the Altman Z-score correctly predicted bankruptcy for a distressed company one year or less from the date it actually filed for Chapter 7 between 82% and 94% of the time (82% for 86 companies between 1969 and 1975, 85% for 110 companies between 1976 and 1995, and 94% for 120 companies between 1996 and 1999.)

For the same samples, the Altman Z-score correctly anticipated 68% to 75% of the bankrupcties and defaults some two years before they occurred.

When Not to Use the Altman Z-Score

The Altman Z-score is most useful in determining the likelihood of bankruptcy occurring in companies found in the Manufacturing and in many Non-Manufacturing industries. Where it doesn't work well is in analyzing financial companies, such as banks or brokerages, or companies with a large financial component in their business, such as General Electric.

More Information

A really good article describing the strengths and weaknesses of the Z-Score is available at Investopedia!