You may not know Edward Altman, but he knows an awful lot about your business -- like whether your company will be bankrupt in the next two years. Cool, right?
In the 1960's Altman developed a corporate finance formula that will accurately predict business bankruptcy more than 90% of the time. The formula, called Altman's Z Score, needs just 8 numbers -- and all of them can be found on your income statement or balance sheet.
How healthy is your business? Take the Z Score Test and find out for sure.
By the way, Edward Altman is a Professor of Finance at the Stern School of Business at New York University. He developed the Z Score formula in 1968, and it is still the best way to tell whether your company is on the brink of disaster. Though the formula was originally designed to predict business bankruptcy among public manufacturing companies, Altman has since designed variations that apply to privately held manufacturing companies (called the Z’ Score") and non-manufacturing companies (the Z'' Score). We highlight both below.
How to Calculate Your Own Business Bankruptcy Score
(1) Grab your financial statements and calculate the following 5 ratios. Its not as hard as it looks: there are only 8 numbers you need.
The Variables You Need to Know:
A= (Current Assets-Current Liabilities)/Total Assets
B=Retained Earnings/Total Assets
C=Earnings before Interest and Taxes/Total Assets
D=Book Value of Equity/ Total Liabilities
(2) Next, decide whether your company is a manufacturer or not. Easy, right? Altman has a different formula for manufacturers and non-manufacturers. Find the formula you need below.
Predicting Business Bankruptcy for Manufacturers (Z'):
Z’ = 0.717 A + 0.847 B + 3.107 C + 0.420 D + 0.
What's it mean? If Z’ is:
- Greater than 2.9, consider yourself ‘safe’
- Between 1.23 and 2.9 you're in the‘grey’ zone - start improvements now!
- Less than 1.23 you're already in trouble.
Predicting Business Bankruptcy for Non-Manufacturers (Z")
Z” = 6.56 A+3.26 B+6.72 C+1.05 D
What's it mean? If Z’' is:
- Greater than 2.6, consider yourself ‘safe’
- Between 1.1 and 2.6 you're in the‘grey’ zone - start improvements now!
- Less than 1.1 you're already in trouble.
Accuracy of Altman's Bankruptcy Z Score
Although broadly accepted, the Altman Z score is most accurate for businesses selling consumer durables, import/export services, and commercial property owners. The model has mostly failed in financial companies (banks and insurers).
For most businesses, a low Z Score is an indicator of declining financial health. Of course, no formula is perfect or always correct, but Altman's Z Score has survived 50 years by being an amazingly accurate way to predict business bankruptcy. If you are scoring low on this scale, it's time to take a long hard look at your business. If you think you might need help, I hope you'll reach out to a CFO before bad turns to worse. (And if it's already too late, well, here's some info on filing for bankruptcy.)
Dedicated to your success, David Worrell
PS: I'm not making this stuff up. Here's my sources, and some great additional reading on how to predict business bankruptcy: An AAII article that breaks it all down, a piece by Ready Ratios (my favorite new tool for assessing financial health) and a nice masters thesis on the topic by Norwegian student Morten Reistad Aasen. Additional research and insight was provided by Consolidated Credit.