Altman Z score has been around since the 1960′s and I have posted about it previously. Originally it was set up and measured the risk of bankruptcy among manufacturing firms. It turns out that in subsequent studies it was found that the original Altman Z score might be under reporting bankruptcies among non-manufacturing firms. Given that used correctly it has a 80%-90% accuracy of predicting bankruptcy in the next year, Altman Z is a great tool, but it must be used correctly.

Here is a review of the area’s that Altman tracked:

Altman’s original formula is a weighted sum of different elements, which are as follows.

T1- Working Capital/Total Assets

T2- Retained Earnings/ Total Assets

T3- Earnings before Interest and Taxes (EBIT)/ Total Assets

T4- Market Value of Equity/Book Value of Total Liabilities

T5- Sales/Total Assets

The revised Altman Z score is Z= 6.56T1+3.26T2+6.72T3+1.05T4

You will note that there is no T5 included in this version of the Altman Z score. It seems that including the T5 increased the likelihood of missing a potential bankrupt company for non manufacturing firms. The revised Altman Z score cannot be used for Manufacturing companies, which requires the original Altman Z score. Nor can it be used for privately held, or publicly traded financial  companies. Also, beware that companies with one time charge offs may show up negatively. Finally the Z score cannot be accurately used for companies with less than $1 million in assets and reportedly more accuracy may be obtained by using companies with more than $100 million in assets. The Altman Z score is probably not all that accurate in the small camp universe I usually tread. It has more narrowly defined uses than I originally realized.

But as the formula was adjusted for non- manufacturing corporations, so were were the weightings for the individual elements.

Greater than 2.6 is considered safe, financially for the next couple of years.

1.1 – 2.6 Gray Zone. Could go either way.

Below 1.1 Distress Zone. Bad. Likely that the company will bankrupt within two years. Not a  lock, but you are warned.

As with any other tool, the Altman Z score has its limitations. But it can be a powerful tool both for avoiding stocks with a high probability of failure and increase the probability of avoiding

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