The Altman Z Score is used to predict the likelihood that a business will go bankrupt within the next two years. The formula is based on information found in the income statement and balance sheet of an organization; as such, it can be readily derived from commonly-available information. Given the ease with which the required information can be found, the Z Score is a useful metric for an outsider who has access to a company's financial statements. In its original form, the Z score formula is as follows:
Z = 1.2A x 1.4B x 3.3C x 0.6D x 0.99E
The letters in the formula designate the following measures:
A = Working capital / Total assets [ Measures the relative amount of liquid assets]
B = Retained earnings / Total assets [Determines cumulative profitability]
C = Earnings before interest and taxes / Total assets [measures earnings away from the effects of taxes and leverage]
D = Market value of equity / Book value of total liabilities [incorporates the effects of a decline in market value of a company's shares]
E = Sales / Total assets [measures asset turnover]
A Z score of greater than 2.99 means that the entity being measured is safe from bankruptcy. A score of less than 1.81 means that a business is at considerable risk of going into bankruptcy, while scores in between should be considered a red flag for possible problems. The model has proven to be reasonably accurate in predicting the future bankruptcy of entities under analysis.
This scoring system was originally designed for manufacturing firms having assets of $1 million or more. Given the targeted nature of the model, it has since been modified to be applicable to other types of organizations.
This approach to evaluating organizations is better than using just a single ratio, since it brings together the effects of multiple items - assets, profits, and market value. As such, it is most commonly used by creditors and lenders to determine the risk associated with extending funds to customers and borrowers.