Vol 12 (2015) - Issue 5

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Predicting Bankruptcy: The Altman Z-Score Model, a Multi-Purpose Tool that Requires Cautious Use

I. Introduction
Although businesses may have varying purposes, the main objective is the same for all of them and it is simply avoiding bankruptcy. Since a company’s bankruptcy is critical for not only its stakeholders but also for the other parties such as its suppliers and creditors, the ability to diagnose the problems of a company in advance is a very valuable asset. The models that provide the ability to predict bankruptcy are important from the national economy perspective as well, since the employment of them is a precondition for guaranteeing the soundness and stability of the banking system and paving the way for incentive compatible, risk sensitive behaviour of debtors.
Different models have their particular strengths and weaknesses and choosing between them for empirical application is not straightforward. Edward Altman’s Z-Score is one of the best known, statistically derived predictive models used to forecast a firm’s impending bankruptcy. This paper provides an overview of the Z-Score model by describing its mechanics, epitomising the alternative uses of the model and criticisms directed against it.

II. Construction of the model, criticisms and alternative uses
Multivariate prediction of bankruptcy as established by using univariate analysis of bankruptcy predictors was initially developed by Beaver (1967, 1968) who found that a number of indicators could discriminate between matched samples of failed and non-failed firms for as long as five years prior to failure. Beaver had conducted a ratio analysis of bankruptcy in 1966 but the main difference was that the T-Test was a univariate model. In Beaver’s study, 7 groups of financial ratios were tested on 79 paired firms (failed and non-failed) and the study indicated (cash flow/ total debt) is the most significant variable in predicting bankruptcy.