Altman’s Z-Score

When it comes to assessing the value of companies, one important factor is the runway involved. Startups often have this idea that after they receive their newest round of funding that they can liberally make purchases on software, marketing, and headcount they weren’t able to before. From working with many startups, the ones that were cost-conscious at Seed stage as well as in Series-D were the ones who always had a healthy enough runway that didn’t request them to spend their money.

One way to measure the health of a company — public or private, is through Altman’s Z-Score. This score calculates the probability that a company will file for bankruptcy within the next 2 years using five important variables, factored into a single linear combination.

Z = 1.2 \; T_{1} \; + 1.4 \; T_{2} \; + 3.3 \; T_{3} \; + 0.6 \; T_{4} \; + 0.99 \; T_{5}

Where the coefficients are tuned to the particular situation and the variables are as follows:

T_{1} = \frac{\textnormal{Working Capital}}{\textnormal{Total Assets}}

T_{2} = \frac{\textnormal{Retained Earnings}}{\textnormal{Total Assets}}

T_{3} = \frac{\textnormal{EBIT}}{\textnormal{Total Assets}}

T_{4} = \frac{\textnormal{Market Value of Equity}}{\textnormal{Total Assets}}

T_{5} = \frac{\textnormal{Net Sales}}{\textnormal{Total Assets}}

According to Altman, the Z-Score was found to be approximately 80% - 90% accurate in predicting a company’s bankruptcy one year before the event, with a Type II error (false positive) of approximately 15% - 20%.