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A previous article by Gina Gutzeit and John Yozzo discussed bankruptcy during "the Great Recession."2 This excellent article also reviewed Prof. Edward Altman's famous Z-Score, which attempts to predict corporate bankruptcy in advance by two years using current financial ratios and data.
In this article, we test the validity of the Z-Score model using a different methodology to include testing for statistical significance. In short, we wanted to assess whether this now-45-year-old model from 1968 has stood the test of time.
The Z-Score is a widely used tool in finance courses as part of teaching financial analysis and ratio analysis. Given the recent financial crisis (from December 2007 until June 2009, referred to by many as "the Great Recession") and the number of companies that have suffered financial difficulties as a result, we thought it would be interesting to test the effectiveness of the Altman Z-Score model. As academics who teach this model to finance students in our classes, we also wanted to determine whether the Altman Z-Score is still a viable tool to teach future financial professionals. Given the severity and the relative speed at which the economy spiraled downward, coupled with the current service/ retail orientation versus manufacturing dominance of the original Altman model, we set out to test the model.
We first present the famous 1968 model in Exhibit 1. Note the specific variables and the Z-Score values, which can produce the important "Distress Zone," which predicts corporate bankruptcy in two years. Altman also recognized that there is a "Gray Area" wherein future bankruptcy cannot be accurately determined; in other words, there is the possibility of error. Finally, there is the nonbankrupt "Safe Zone." The calculations of the model are simple, the data come from balance sheet and income statements, and the results are easy to interpret.
Expanding Application of the Z-Score Model
In their 2011 article, Gutzeit and Yozzo noted the importance of the fourth of Altman's Z-Score variables: the Market Value of Equity (MVE) divided by the Book Value of Debt (BVD) (see Exhibit 1). They state: "There is little doubt that the Z-Score's general robustness and its high accuracy rate with respect to correctly identifying near-term defaults is largely attributable to its one ratio with a market dimension:...