Altman Z-Score
Quick Definition
A formula combining five financial ratios to predict the probability of a company going bankrupt within two years, with scores below 1.8 indicating high risk.
Key Takeaways
- Z-Score combines 5 ratios: liquidity, profitability, leverage, solvency, and efficiency
- Above 2.99 = Safe, 1.81-2.99 = Grey Zone, below 1.81 = Distress Zone
- Originally designed for manufacturing; modified versions exist for private and non-manufacturing firms
- 80-90% accuracy in predicting bankruptcy one year out, but has limitations
What Is Altman Z-Score?
The Altman Z-Score is a quantitative model developed by Professor Edward Altman in 1968 that predicts the likelihood of a company entering bankruptcy within two years. The formula combines five weighted financial ratios: Z = 1.2×(Working Capital/Total Assets) + 1.4×(Retained Earnings/Total Assets) + 3.3×(EBIT/Total Assets) + 0.6×(Market Value of Equity/Total Liabilities) + 1.0×(Sales/Total Assets). Each component captures a different aspect of financial health: liquidity, profitability, leverage, solvency, and asset efficiency. The interpretation zones are: Z > 2.99 = "Safe Zone" (low bankruptcy risk), 1.81 < Z < 2.99 = "Grey Zone" (moderate risk), and Z < 1.81 = "Distress Zone" (high bankruptcy risk). The original model was designed for manufacturing companies. Altman later created modified versions: the Z'-Score for private companies (replaces market cap with book value of equity) and the Z''-Score for non-manufacturing and emerging market companies. While the Z-Score has shown 80-90% accuracy in predicting bankruptcy one year out in various studies, it has limitations — it works best for manufacturing firms, may not capture sudden liquidity crises, and doesn't account for off-balance-sheet items.
Altman Z-Score Example
- 1A struggling retailer has a Z-Score of 1.3, placing it deep in the Distress Zone — within 18 months, the company files for Chapter 11 bankruptcy.
- 2An investor screens for value stocks with Z-Scores above 3.0 to avoid "value traps" — companies that appear cheap but are heading toward financial distress.
Related Terms
Piotroski F-Score
A 9-point scoring system that evaluates a company's financial strength based on profitability, leverage, liquidity, and operating efficiency.
Current Ratio
A liquidity ratio measuring a company's ability to pay short-term obligations by comparing current assets to current liabilities.
Debt-to-Equity Ratio
A financial leverage ratio comparing a company's total debt to its shareholders' equity, indicating how much the company is financed by debt versus owned funds.
Interest Coverage Ratio
A measure of how easily a company can pay interest on its debt, calculated as EBIT divided by interest expense.
Working Capital
The difference between a company's current assets and current liabilities, measuring short-term financial health and operational efficiency.
Revenue
The total amount of money a company earns from its business activities before any expenses are deducted, also called sales or top line.
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