In 1968 a Professor named Edward Altman devised a formula for predicting bankruptcy. Initially, the Z score was found to be 72% accurate within two years with a 6% false positive rate. In subsequent testing, it was found to be 80-90% accurate within one year with a 15-20% false positive error rate. In other words, if a company fails this test, you are treading way over your head, unless bankruptcy is your desired outcome. In which case you may have found a good shorting opportunity.

For the math avoiders in the group here is a website with an Altman -Z calculator. I don’t use things like this because I am never sure of their accuracy, but it may be better than trying to calculate the Z score on your fingers.

Here is the math that goes with the Altman Z score. Altman’s 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

So the actual formula is Z= 1.2T1 + 1.4T2 + 3.3T3 + .6T4 + .999T5.

I always check companies before  I invest. I have been scared off more than once by a low Z score. What is good and what is bad?

Greater than 3.0 is considered safe.

1.8-2.99 Gray Zone

Below 1.8 Distress Zone. Bad.

I have added an update to the Altman Z score, which before you use it for investing you should check out at Altman Z Score Redux.

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