What the Altman Z‑Score measures
– Definition: The Altman Z‑Score is a composite number that estimates a publicly traded company’s risk of bankruptcy by combining five financial ratios into one score. It aims to capture profitability, leverage, liquidity/solvency, and operating scale in a single metric.
Brief history and scope
– Edward I. Altman (NYU Stern) developed the original model in the late 1960s using discriminant analysis on corporate financial data. Over decades he updated the approach and produced variations (including a later “Z‑Score Plus”) that adapt the model to private firms and non‑manufacturing companies. Early studies reported classification accuracy in the 80–90% range for the tested samples.
Formula and components
– Formula: Z = 1.2·A + 1.4·B + 3.3·C + 0.6·D + 1.0·E
– A = Working capital / Total assets
– Working capital = Current assets − Current liabilities. Measures short‑term liquidity.
– B = Retained earnings / Total assets
– Captures cumulative profitability and reinvested earnings.
– C = EBIT / Total assets
– EBIT = Earnings before interest and taxes. Measures operating profitability relative to asset base.
– D = Market value of equity / Total liabilities
– Market value of equity = shares outstanding × share price. This links market perceptions to the balance sheet.
– E = Sales / Total assets
– Activity/turnover: how effectively assets produce revenue.
Interpreting the score (original thresholds)
– Z > 3.0: “Safe” zone — low probability of bankruptcy.
– 1.8 ≤ Z ≤ 3.0: “Gray” zone — indeterminate; warrants further analysis.
– Z < 1.8: “Distress” zone — higher probability of bankruptcy.
– Note: Professor Altman has observed that in recent data sets a score drifting toward 0 is a stronger alarm signal than the historical 1.8 cutoff, so treat thresholds as guidelines, not absolute rules.
Limitations and practical cautions
– Designed originally for publicly traded manufacturing firms; alternate versions are more suitable for private or non‑manufacturing companies.
– D (market value of equity) is sensitive to stock price volatility; short‑term market moves can change Z even if fundamentals are steady.
– Accounting differences (GAAP vs. local standards) and one‑time items can distort ratios.
– It’s an indicator, not a certainty — false positives and false negatives occur.
– Use alongside other credit metrics, cash‑flow analysis, and qualitative factors (management, industry outlook, covenant schedules).
Step‑by‑step checklist to compute and