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The Altman zeta model is a formula that predicts whether a company will go bankrupt within the following two years. Extensive testing has found this formula to be very accurate, as high as 90% in some cases. It works by weighting various aspects of a company’s assets and earnings in order to generate a final score. The original model was designed for certain manufacturing companies, but it has since expanded to cover other areas.
While several researchers had made attempts at bankruptcy prediction from as early as the 1930s, the original zeta model was the first real success. The zeta model was released in 1968 and, at that time, its purpose was more educational than predictive. It was used for several years in the academic world as a method of predicting corporate success or failure.
Over the next 15 years, the formula was tested against real-world situations until it was adopted by the financial world in the mid-1980s. In Altman’s original testing, the zeta model was found to have a 72% accuracy with a false positive chance of 6%. These numbers made it far more accurate than any other model currently used. Since the initial testing, the model has been put up against a huge number of cases, and it is believed to have an 85% to 90% accuracy rate with a false positive rate of 15 to 20%, still far above other models.
The zeta model works by taking various numerical values and weighting them in accordance with their value to the company’s long-term success. The two factors that are least valuable to a company are the scores for market value of equity over total liabilities and sales over total assets. The mid-range scores are working capital and retained earnings over total assets. The most important factor by far is earnings before interest and taxes over total assets.
After putting the required numbers into the zeta model, it gives a number that is used to rate the business. The lower the number, the closer that business is to bankruptcy. Generally speaking, any company with a score of 1.8 or lower is in trouble, while a score of 3.0 or higher means the company is safe. If the score is between 1.8 and 3.0, then it is in a danger area; depending on the company’s policies and market fluctuations it could go either way.
The original zeta model was designed for public manufacturing businesses that had assets greater than $1 million dollars US Dollars (USD). Over the years, new models have come out to cover other circumstances such as privately-held companies or non-manufacturing companies. The zeta score cannot predict the success of some companies, such as financial institutions or non-profit organizations, as their bookkeeping practices do not mesh with the model’s methods.