The Altman Z-Score: A Comprehensive Explanation

The Altman Z-Score is a financial model developed by NYU Professor Edward Altman in 1968 to predict the likelihood of a company going bankrupt within two years. This quantitative model uses multiple corporate income and balance sheet values to measure a company’s financial health.

What the Z-Score Measures

The Z-Score combines five key financial ratios that collectively assess:

1. Liquidity – The company’s ability to meet short-term obligations
2. Profitability – The company’s earnings performance
3. Leverage – The company’s debt levels relative to equity
4. Solvency – The company’s ability to meet long-term obligations
5. Activity – The company’s efficiency in using assets to generate sales

The Original Z-Score Formula (for Manufacturing Firms)

The original formula is:

Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

• A = Working Capital / Total Assets
  (Measures liquidity and ability to fund operations)
• B = Retained Earnings / Total Assets
  (Measures cumulative profitability and age of firm)
• C = EBIT / Total Assets
  (Measures operating efficiency before interest and taxes)
• D = Market Value of Equity / Total Liabilities
  (Measures market confidence and leverage)
• E = Sales / Total Assets
  (Measures asset turnover efficiency)

Interpretation of Scores

The model classifies companies into three zones:

1. Safe Zone (Z > 2.99)
   • Low probability of bankruptcy
   • Company appears financially healthy
2. Grey Zone (1.81 < Z ≤ 2.99)
   • Moderate risk of financial distress
   • Caution warranted
   • Company may be vulnerable to economic downturns
3. Distress Zone (Z ≤ 1.81)
   • High probability of bankruptcy within 2 years
   • Severe financial distress likely
   • Creditors should be particularly concerned

Practical Applications

The Z-Score is used by:

1. Credit Analysts: To assess default risk
2. Investors: To screen potential investments
3. Management: For internal financial health monitoring
4. Auditors: To identify going concern issues
5. M&A Professionals: For due diligence

Strengths of the Model

• Proven accuracy: Originally 72% accurate in predicting bankruptcy
• Quantitative: Removes subjective judgment
• Simple calculation: Uses standard financial statement items
• Early warning: Predicts trouble before it becomes obvious

Limitations

• Industry-specific: Original model works best for manufacturing firms
• Market-dependent: Uses market value which can be volatile
• Financial statement quality: Relies on accurate reporting
• Time-bound: Designed for 2-year prediction window

Variations

Professor Altman later developed modified versions for:

1. Private companies (using book value instead of market value)
2. Non-manufacturing companies
3. Emerging markets
4. Non-profit organizations

Conclusion

The Altman Z-Score remains one of the most widely used financial distress prediction models over 50 years after its creation. While it shouldn’t be used in isolation, it provides valuable insight when combined with other financial analysis tools. The model works best when applied consistently over time to track trends in a company’s financial health.