The original Altman Z-Sore was developed for US manufacturing companies and the formula is was as follows:
X1 = Working Capital (Current Assets less Liabilities) / Total Assets. Measures liquid assets in relation to the size of the company.
X2 = Retained Earnings / Total Assets. Measures profitability that reflects the company's age and earning power.
X3 = Earnings Before Interest and Taxes / Total Assets. Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.
X4 = Market Value of Equity / Book Value of Total Liabilities. Adds market dimension that can show up security price fluctuation as a possible red flag.
X5 = Sales / Total Assets. Standard measure for total asset turnover (varies greatly from industry to industry).
The five variables are then weighted together according to the following formula:
Altman Z-Score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5.
A Z-Score above 2.99 suggests that a company is in the Safe Zone based on the financial figures only. A Z-Score between 1.8 and 2.99 is in the Grey Zone which suggests there is a good chance of the company going bankrupt within the next two years of operations. Meanwhile, a Z-Score below 1.80 is in the Distress Zone which indicates a high probability of distress within this time period. We have displayed the scoring system in the following chart to make it easier to understand:
We have downloaded the Z-Score in FY15 for 3,500 non-finance companies across Asia with a market capitalisation exceeding US$1bn. A surprisingly large number of companies, 22% of total, return a score of less than 1.8, putting them in the danger zone. Around 59% of these are located in Hong Kong and China. Indeed, Hong Kong has the highest incidence rate companies in the distressed zone at 35% of total, as the following table shows. Meanwhile, on a sector basis, Electric Utilities, Real Estate and Airlines have the highest incidence of companies in distress.
In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years before the event, with a Type II error (classifying the firm as bankrupt when it does not go bankrupt, or false negatives) of 6% (Altman, 1968). In a series of subsequent tests covering three periods over the next 31 years (up until 1999), the model was found to be approximately 80%–90% accurate in predicting bankruptcy one year before the event, with a Type II error of approximately 15%–20% (Altman, 2000). However, this ratio has come under some criticism in recent years given that is was originally designed for manufacturing companies back in the 1960s and drew upon a relatively small sample size.
While Altman’s Z-Score was initially designed for US manufacturing companies, we have incorporated later iterations designed for non-manufacturing and emerging market companies. In these iterations, the 4th variable, which compares market capitalisation to total liabilities, is replaced with equity to total liabilities, as shown below:
X4 = Book Value of Equity / Total Liabilities. Gauges a company’s leverage.
Z-Score bankruptcy model: Z = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4
Z-Score bankruptcy model (Emerging Markets): Z = 3.25 + 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4
Zones of discriminations:
Z > 2.6 -“Safe” Zone
1.1 < Z < 2.6 -“Grey” Zone
Z < 1.1 -“Distress” Zone