Z-Score model is an accurate forecaster of failure up to two years prior to distress. It can be considered the assessment of the distress of industrial corporations.
Altman Z-Score is calculated with this formula:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
X1 = working capital/total assets,
X2 = retained earnings/total assets,
X3 = earnings before interest and taxes/total assets,
X4 = market value equity/book value of total liabilities,
X5 = sales/total assets.
The zones of discrimination were as such:
Distress Zones - 1.81< Grey Zones< 2.99 - Safe Zones
Study by Altman found that companies that are in Distress Zone have more than 80% of chances of bankruptcy in two years.
X1: The working capital/Total Assets
ratio is a measure of the net liquid assets of the firm relative to the total capitalization. Working capital is defined as the difference between current assets and current liabilities.
X2: Retained Earnings
: the RE/TA ratio measures the leverage of a firm. Those firms with high RE, relative to TA, have financed their assets through retention of profits and have not utilized as much debt.
X3, Earnings Before Interest and Taxes/Total Assets
(EBIT/TA): This ratio is a measure of the true productivity of the firms assets, independent of any tax or leverage factors.
X4, Market Value of Equity/Book Value of Total Liabilities (MVE/TL): The measure shows how much the firms assets can decline in value (measured by market value of equity plus debt) before the liabilities exceed the assets and the firm becomes insolvent.
(S/TA): The capital-turnover ratio is a standard financial ratio illustrating the sales generating ability of the firms assets.
Read more about Altman Z-score
and the original research.