Altman Z-Score: A Comprehensive Overview
The Altman Z-Score is a financial model developed by Edward I. Altman
in 1968 to predict the likelihood of a company going bankrupt. It uses
a combination of five financial ratios calculated from a company’s financial
statements and applies a weighted formula to assess the financial health of a
firm.
It’s especially useful for analysts, investors, and creditors to evaluate credit
risk and the probability of default, particularly in manufacturing or
publicly listed firms.
Why Was the Z-Score Developed?
Altman created this model using multivariate discriminant analysis to find a
linear combination of financial ratios that best distinguishes between
companies that went bankrupt and those that did not. It helps answer the
question:
“How likely is it that this company will go bankrupt in the next two
years?”
Altman Z-Score Formula
For public manufacturing companies, the formula is:
Z = 1.2 * X1 + 1.4 * X2 + 3.3 * X3 + 0.6 * X4 + 1.0 * X5
Where:
Variab
Definition Calculation
le
(Current Assets - Current
X1 Working Capital / Total Assets
Liabilities) / Total Assets
X2 Retained Earnings / Total Assets Cumulative profit reinvested
Earnings Before Interest & Tax
X3 Measures profitability
(EBIT) / Total Assets
Market Value of Equity / Book
X4 Reflects market confidence
Value of Total Liabilities
Variab
Definition Calculation
le
X5 Sales / Total Assets Asset turnover or efficiency ratio
Modified Versions
There are adaptations for different types of firms:
1. Private Manufacturing Companies:
o Replace X4 with: Book Value of Equity / Total Liabilities
2. Non-Manufacturing or Emerging Market Firms (Z'' Score):
Z'' = 6.56*X1 + 3.26*X2 + 6.72*X3 + 1.05*X4
(Note: X4 in Z'' is Net Income / Total Assets)
Interpretation of Z-Score
Z-Score
Interpretation
Range
Safe Zone – Low risk of
Z > 2.99
bankruptcy
1.81 < Z <
Grey Zone – Moderate risk
2.99
Distress Zone – High risk of
Z < 1.81
bankruptcy
Note: Thresholds can vary slightly depending on industry and country.
What Does Each Component Tell Us?
X1 – Liquidity: Measures the firm’s ability to cover short-term
obligations.
X2 – Cumulative Profitability: Shows long-term profitability and
stability.
X3 – Operational Efficiency: Indicates how effectively assets
generate operating profit.
X4 – Market Confidence: Evaluates how the market values the
company vs. its debt.
X5 – Asset Utilization: Reveals how efficiently a company uses its
assets to generate revenue.
Use Cases of Altman Z-Score
Credit risk assessment by banks and lenders
Investor analysis to avoid high-risk investments
Internal risk monitoring by companies or CFOs
Auditors evaluating going-concern issues
M&A Due Diligence to assess acquisition risks
Limitations of the Z-Score
Originally designed for manufacturing firms; less accurate for
service companies.
Assumes stable accounting policies and doesn't capture off-balance-
sheet risks.
Relies heavily on historical data and doesn’t incorporate qualitative
factors.
Market value input makes it less stable during high-volatility
periods.
Example Calculation
Let’s say a company has:
Working Capital = $1M
Total Assets = $10M
Retained Earnings = $2M
EBIT = $1.5M
Market Value of Equity = $5M
Total Liabilities = $4M
Sales = $8M
Now calculate:
X1 = 1 / 10 = 0.1
X2 = 2 / 10 = 0.2
X3 = 1.5 / 10 = 0.15
X4 = 5 / 4 = 1.25
X5 = 8 / 10 = 0.8
Z = 1.2(0.1) + 1.4(0.2) + 3.3(0.15) + 0.6(1.25) + 1.0(0.8)
Z ≈ 0.12 + 0.28 + 0.495 + 0.75 + 0.8 = 2.445
Interpretation: The company is in the grey zone—financially stable but
needs monitoring.
Final Thoughts
The Altman Z-Score remains a powerful tool, even decades after its creation.
While it's not a crystal ball, it offers quantitative insight into financial
health and acts as an early warning system for financial distress. Used
alongside other models and qualitative assessments, it can significantly
strengthen risk analysis and financial decision-making.
