Chartered Financial Analyst (CFA) Practice Exam Level 2

What does the Altman-Z Score primarily predict?

1. Potential for stock price increase

2. Probability of a company going bankrupt

3. Future cash flow generation

4. Market share growth

The correct answer is: Probability of a company going bankrupt

The Altman Z-Score is a financial metric that primarily predicts the probability of a company going bankrupt. It utilizes a combination of financial ratios derived from various data points, including profitability, leverage, liquidity, solvency, and activity ratios, to assess a company's likelihood of defaulting on its obligations. The Z-Score is calculated using a formula that typically includes elements like earnings before interest and taxes (EBIT), working capital, retained earnings, total assets, and market value of equity. The resulting score categorizes a company into different risk zones—usually indicating whether it is in the safe zone, the gray zone, or the distress zone—thereby providing a clear indication of financial health and bankruptcy risk. Understanding that the Altman Z-Score serves this specific predictive function is crucial, as it helps investors, creditors, and analysts make informed decisions regarding the potential risk associated with investing in or lending to a company. This prediction of bankruptcy probability is particularly useful for evaluating companies in distress or those facing financial difficulties.