The Altman Z-Score After 50 Years: Use And Misuse

Feb. 14, 2016 5:46 PM ET4 Comments

By Larry Cao, CFA

This is the second installment in my interview series with Edward Altman in which we discuss the most advisable and problematic applications of the Altman Z-score. For additional details of our conversation, check out the first installment.

Larry Cao, CFA: It's been almost 50 years since the Z-score was first developed. Would you suggest doing anything differently today?

Edward Altman: Over the years, the so-called cutoff scores in the model has been retained by the people who applied the model. But in my opinion, that is not the best thing to do.

Over time, I began to observe that the average Z-score of American companies mainly, but even global companies, began to get lower and lower. [The bond market] became more available for both investment grade and non-investment grade companies and companies periodically took advantage of low interest rates to raise their leverage. As a result, the financial risk of companies began to increase. Also with global competition, companies' profitability began to diminish. And so the average Z-score became lower and lower, which meant that more firms would have been classified as likely bankrupt using the Z model if we kept the original cutoff scores. In order to modernize the model, we needed bond-rating equivalence of the scores, which changes constantly and adds on an updated nature to the interpretations of the scores.

We now think the most important attribute of the Z model is the probability of default (PD), not the zone classification - safe, grey, or distress. We do it in a two-step process. We get the PD from the score of the company, whether it be from Z, or Z prime, or Z double prime. And then we look at the bond rating equivalent as of that point in time. For example, 2015 - the average B-rate company has a Z-score [of] about 1.6. That would be in a distress zone back

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