Altman Z-score: The formula for predicting bankruptcies

Altman Z-score: The formula for predicting bankruptciesOne of the main concerns of a value investor is to avoid investing in companies that could end up in bankruptcy, which can cause us to lose most or all of the money invested. A simple way to analyze the financial strength of a company is to use an econometric formula, the Altman Z-score. In this article we will look at the Altman Z-score formula, how to use it, and its accuracy when predicting company bankruptcies.

La  fórmula Altman Z-score

The Altman Z-score formula was created in 1.960 by the New York University professor Edward Altman. This simple formula measures the probability that a business will fail.

The Altman Z-score formula consists of the following calculation:

Altman Z-score = 1,2 * T1 + 1,4 * T2 + 3,3 * T3 + 0,6 * T4 + 1,0 * T5

Where:

  • T1: (Working Capital / Total Assets)
  • T2: (Undistributed Profits / Total Assets)
  • T3: (EBITDA / Total Assets)
  • T4: (Market Capitalization / Total Debt)
  • T5: (Net Sales / Total Assets)

How to use the Altman z-score to predict bankruptcies?

The probability of bankruptcy of a company will depend on the result of the Altman Z-score formula. Depending on the result, the company may be in the safe zone, gray zone or in the danger zone.

  • Z-score higher than 2,99: Safe zone, in principle there is no need to worry.
  • Z-score between 1,81 and 2,99: Gray zone, it is likely that the company could fail in the next 2 years.
  • Z-score less than 1,81: Danger zone of imminent bankruptcy.

The accuracy of the Altman Z-score in predicting bankruptcies

The accuracy of the Altman Z-score formula is 72% 2 years ahead of the bankruptcy date, with a false negative rate of 6%.

Over a 31-year trial period, this formula was 80-90% accurate in predicting bankruptcies one year before they occurred, with a false-negative rate of 15-20%. %.

Therefore, we can say that Altman's formula for predicting bankruptcies is quite accurate. However, it is not an infallible formula, so we must combine its use with a qualitative analysis of the company to help determine if we are facing a future bankrupt company.