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Financial Ratio To Predict A Company’s Bankruptcy Within a Two Years Period

In earlier articles we have gone through many ratios to assess the liquidity, profitability, market based ratio, activity of asset utilised,gearing level and cash sufficiency of a company.

There is a very interesting ratio which can assist the managers to predict the probability of a company entering bankruptcy within a 2 year period.
That ratio is the Altman Z System. This powerful diagnostic tool uses almost the same type of financial ratio we used.

Introduction to Altman Z System:
The person who discovered this “system” is Mr. Edward Altman, who is an economist. Yes, an economist! Not surprisingly to say that as econometrics is a very advanced study of mathematics and is part of the study of Economics.
He was able to use computer simulations to study companies, in order to come up with his Z-Score Formula for Predicting Bankruptcy. The system is about 72% - 80% accurate.

It combines five (5) common business ratios, using a weightage system designed by Altman. It was originally derived based on data from manufacturing firms but this has been modified for firms in general.

Appended below are the various formulas for Altman Z-Score System:
• Formula Altman Z-Score: (PUBLIC COMPANIES)

• Working Capital X 1.2
Total Assets

• Retained Earnings X 1.4
Total Assets

• Earnings be interest & tax X 3.3
Total Assets

• Market Value of Equity X 0.6
Total Liabilities

• Sales X 0.999
Total Assets

Original Z-score for PUBLIC MANUFACTURER
3 Or > Bankruptcy is not likely
1.8 Or > Bankruptcy is likely
(Between 1.8 to 3.0 – is the gray area )
Probabilities of bankruptcy within the above ranges are 95% for 1 year
and 70% within two years.

Model a Z-score for PRIVATE MANUFACTURER
2.90 or > Bankruptcy is not likely
1.23 or < Strong indicator bankruptcy is likely
Probabilities of bankruptcy in the above ranges are 95% for 1 year
and 70% within two years.

Model a Z-score for PRIVATE GENERAL FIRM / NON MANUFACTURER
2.60 or > Bankruptcy is not likely
1.10 or < Strong indicator bankruptcy is likely
Probabilities of bankruptcy in the above ranges are 95% for 1 year
and 70% within two years.

• Formula Altman Z-Score: (PRIVATE COMPANIES)

• Working Capital X 0.717
Total Assets

• Retained Earnings X 0.847
Total Assets

• Earnings be interest & tax X 3.107
Total Assets

• Market Value of Equity X 0.420
Total Liabilities

• Sales X 0.998
Total Assets

This entry was posted on Wednesday, October 17th, 2007 at 7:54 am and is filed under d. Interpretation. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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