Altman Z-Score and

BENEISH’S M-SCORE

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 Edward Altman’s Z-Score

• The Z-Score formula for predicting bankruptcy was published in 1968 by

Edward Altman , who was at the time, an Assistant Professor of Finance at New
York University.
• The formula may be used to predict the probability that a firm will go into
bankruptcy within two years.
• Z-Scores are used to predict corporate defaults and an easy-to-calculate control
measure for the financial distress status of companies in academic studies
• The Z-Score uses multiple corporate income and balance sheet values to measure
the financial health of a company
• In its initial test, the Altman Z-Score was found to be 72% accurate in predicting
bankruptcy two years prior to the event.
• In a series of subsequent tests covering three different time periods over the next
31 years (up until 1999), the model was found to be approximately 80-90%
accurate in predicting bankruptcy one year prior to the event.

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Forecasting Distress With Discriminant Analysis
Linear Form
Z = a1x1 + a2x2 + a3x3 + …… + anxn

Z = Discriminant Score (Z Score)

a1 an = Discriminant Coefficients (Weights)
x1 xn = Discriminant Variables (e.g. Ratios)
x x x
x x x
x x x
x
Example x
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x x x x
EBIT x x
x
x
x
x
x
x
x
x
TA x x
x
x
x
x x x
x x x x
x

EQUITY/DEBT 3

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Original Z-Score Component Definitions

T1 = Working Capital / Total Assets

T2 = Retained Earnings / Total Assets

T3 = EBIT / Total Assets

T4 = Market Value of Equity / Total Liabilities

T5 = Sales/ Total Assets

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 Explanation of the ratios

• Ratio A, Working Capital / Total Assets,

• is a liquidity measure. Working capital is comprised of cash and any other
assets that can be turned into cash on fairly short notice.
• The more working capital a firm has, the more cushion it has to meet
any bills coming due.
• Ratio B, Retained Earnings / Total Assets,
• is a measure of leverage. It tells us whether the firm is paying for assets using
profits or using debt.
• A high ratio indicates that profits are being used to fund growth,
• while a low ratio indicates that growth is being financed through
increasing debt levels.-

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 Explanation of the ratios contii......

• Ratio C, EBIT / Total Assets,

• is a profitability measure also known as returnon assets (ROA).
• It measures the amount of operating income generated by each dollar of
assets
• Ratio D, Market Cap / Total Liabilities,
• is a measure of the markets confidence in the company as reflected in its stock
price.
• If the ratio falls below1.0, then the market is saying that the firm is worth
less than what it owes, or in other words, insolvent.
• Ratio E, Sales / Total Assets,
• is a measure of efficiency in that it describes the amount of sales generated by
each dollar of assets

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 Interpretation of the ratios

It should now be easier to see why the Z-score is such a good

measure of a firms financial health.
•A healthy firm(A) maintains enough liquid assets to pay whatever
bills are due,
•(B) funds its growth with profits,
•(C) invests in assets that generate profits for its owners,
•(D) gets a vote of confidence from investors via its share price, and
•(E) converts its investments into revenues for the company.

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 Z-Score estimated for Public Companies

Z-Score Bankruptcy Model

Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.999T5

T1 = Working Capital / Total Assets Z > 2.99 - “Safe” Zone

1.80 < Z < 2.99 - “Grey”
T2 = Retained Earnings / Total Assets Zone

T3 = EBIT / Total Assets Z < 1.80 - “Distress” Zone

T4 = Market Value of Equity / Total Liabilities

T5 = Sales/ Total Assets

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 Additional Altman Z-Score Models:

Private Firm Model (1968)

Non-U.S., Emerging Markets Models for Non
Financial Industrial Firms (1995)
e.g. Latin America (1977, 1995), China (2010), etc.
Sovereign Risk Bottom-Up Model (2010)
SME Models for the U.S. (2007) & Europe
e.g. Italian Minibonds (2016), U.K. (2017), Spain (?)

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 Z’ Score Private Firm Model

Z’ = .717T1 + .847T2 + 3.107T3 + .420T4 + .998T5

T1 = Working Capital / Total Assets Z > 2.99 - “Safe” Zone

1.23 < Z < 2.99 - “Grey”
T2 = Retained Earnings / Total Assets Zone
Z < 1.23 - “Distress” Zone
T3 = EBIT / Total Assets

T4 = Market Value of Equity / Total Liabilities

T5 = Sales/ Total Assets

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 Z-Score estimated for Non-Manufacturer Firms

Z-Score Bankruptcy Model

Z = 6.56T1 + 3.26T2 + 6.72T3 + 1.05T4 Z > 2.60 - “Safe” Zone

1.1 < Z < 2.60 - “Grey” Zone
T1 = Working Capital / Total Assets
Z < 1.1 - “Distress” Zone

T2 = Retained Earnings / Total Assets

T3 = EBIT / Total Assets

T4 = Market Value of Equity / Total Liabilities

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 Z” Score Model for Manufacturers, Non-Manufacturer
Industrials; Developed and Emerging Market Credits (1995)

Z” = 3.25 + 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4

X1 = Current Assets - Current Liabilities
Total Assets
Z > 2.60 - “Safe” Zone
X2 = Retained Earnings
1.1 < Z < 2.60 - “Grey” Zone
Total Assets Z < 1.1 - “Distress” Zone

X3 = Earnings Before Interest and Taxes

Total Assets
X4 = Book Value of Equity
Total Liabilities

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3 easy steps to calculate Z score

Step
1
2
3

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 Step 1

To calculate a manufacturer's Z-score from scratch, the first step is

to identify the seven items listed on the balance sheet and income
statement used in the calculation:

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 Step 2

Together, these seven figures are used to create five financial ratios,
each identified by Altman as having the greatest forecasting power
as to a company's financial strength:

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 Step 3

The third and final step is to use these ratios in the Z-score formula
to create the final value:

Z-Score Bankruptcy Model

Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.999T5

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BENEISH’S M-SCORE

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 BENEISH’S M-SCORE
• Beneish’s M-Score is a mathematical model that uses eight financial ratios
weighted by coefficients
• To identify whether a company has manipulated its profits. 
• It was created by Professor Messod Beneish who published a paper in June
1999 called The Detection of Earnings Manipulation.
• Beneish surmises that companies are incentivized to manipulate profits
• if they have high sales growth,
• deteriorating gross margins,
• rising operating expenses and
• rising leverage. 
• They are likely to manipulate profits by accelerating
• sales recognition,
• increasing cost deferrals,
• raising accruals and
• reducing depreciation. 

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 BENEISH’S M-SCORE
• Beneish’s M-Score is a mathematical model that uses eight financial ratios
weighted by coefficients
• To identify whether a company has manipulated its profits. 
• It was created by Professor Messod Beneish who published a paper in June
1999 called The Detection of Earnings Manipulation.
• Beneish surmises that companies are incentivized to manipulate profits
• if they have high sales growth,
• deteriorating gross margins,
• rising operating expenses and
• rising leverage. 
• They are likely to manipulate profits by accelerating
• sales recognition,
• increasing cost deferrals,
• raising accruals and
• reducing depreciation. 

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BENEISH’S M-SCORE

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 BENEISH’S M-SCORE
• Days’ Sales in Receivables Index (DSRI): A large increase in receivable days might suggest
accelerated revenue recognition to inflate profits.
•  (Net Receivablest / Salest) / (Net Receivablest-1 / Salest-1)
• Gross Margin Index (GMI): A deteriorating gross margin sends a negative signal about a firm’s
prospects and creates an incentive to inflate profits.
• GMI = [(Salest-1 - COGSt-1) / Salest-1] / [(Salest - COGSt) / Salest]
• Asset Quality Index (AQI): An increase in long term assets (for example, the capitalisation of costs),
other than property plant and equipment, relative to total assets indicates that a firm has potentially
increased its involvement in cost deferral to inflate profits.
• AQI = [1 - (Current Assetst + PP&Et + Securitiest) / Total Assetst] / [1 - ((Current Assetst-1 + PP&Et-
1 + Securitiest-1) / Total Assetst-1)]
• Sales Growth Index (SGI): High sales growth does not imply manipulation but high growth
companies are more likely to commit financial fraud because their financial position and capital needs
put pressure on managers to achieve earnings targets.
• If growth firms face large stock prices losses at the first indication of a slowdown, they may have
greater incentives to manipulate earnings.
• SGI = Salest / Salest-1

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 BENEISH’S M-SCORE
• Depreciation (DEPI): A falling level of depreciation relative to net fixed assets raises the possibility
that a firm has revised upwards the estimated useful life of assets, or adopted a new method that is
income increasing.
• DEPI = (Depreciationt-1/ (PP&Et-1 + Depreciationt-1)) / (Depreciationt / (PP&Et + Depreciationt))
• Sales, General and Administrative Expenses (SGAI): Analysts might interpret a disproportionate
increase in SG&A relative to sales as a negative signal about a firm’s future prospects, thereby creating
an inventive to inflate profits.
• SGAI = (SG&A Expenset / Salest) / (SG&A Expenset-1 / Salest-1)
• Leverage Index (LVGI): Leverage is measured as total debt relative to total assets. An increase in
leverage creates an incentive to manipulate profits in order to meet debt covenants.
• LVGI = [(Current Liabilitiest + Total Long Term Debtt) / Total Assetst] / [(Current Liabilitiest-1 + Total
Long Term Debtt-1) / Total Assetst-1]
• Total Accruals to Total Assets (TATA): Total accruals are calculated as the change in working capital
(other than cash) less depreciation relative to total assets. Accruals, or a portion thereof, reflect the
extent to which managers make discretionary accounting choices to alter earnings. A higher level of
accruals is, therefore, associated with a higher likelihood of profit manipulation.
• TATA = (Income from Continuing Operationst - Cash Flows from Operationst) / Total Assetst

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 BENEISH’S M-SCORE

• Beneish M-Score = -4.84 + 0.92*DSRI + 0.528*GMI +

0.404*AQI + 0.892*SGI + 0.115*DEPI –
0.172*SGAI + 4.679*TATA – 0.327*LVGI

 If M-Score is less than -2.22 - the company is unlikely to be a manipulator.

 If M-Score is greater than -2.22 - the company is likely to be a manipulator.

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