Altman Z-score is a financial model to predict the likelihood business failure in a company and created by Edward I. Altman in 1968. Altman developed a z-score model using ratios as its foundation. The purpose of the Z-score model is to measure a company's financial health and predict the probability of failure up to 2-3 years in advance by using a weighting system combined with four or five financial ratios. Altman created three different Z-score models which is original Z-score model, model "A" z-score and model "B" z-score.
The original Z-score model was developed in 1968. This predictor is a statistical data from public manufacturing that combines with five financial ratios with the opinion that ratios measuring profitability, liquidity and insolvency of the company. First ratio is working capital/total assets (X1). This financial ratio is determine the ability of company to cover its short term financial obligation. Altman's research founds this ratio to be more helpful than other liquidity ratios. Second ratio is retained earning/total assets (X2) measure the ability of company to accumulate earnings by using its assets. The lower the ratio, the more a company is funding assets by borrowing instead of through retained earning which increase the risk of bankruptcy if the firm cannot meet its debt obligations. Next, earning before interest and taxes/total assets (X3) is one of the ratio. This ratio estimates that cash supply available for allocation to creditors, the government, and shareholders. Altman classifies the ratio that measure the profitability better than cash flow. The fourth ratio is market value of equity/book value of total debt (X4). This ratio shows how much a company's market value could decline before liabilities exceeded assets. Unlike the other ratio components used by Z-score, market value is not based purely on fundamentals. Generally speaking, the higher the market capitalization, the higher the firm can survive going forward. The...
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