What it means
Economist Edward Altman developed the model in the late 1960s by studying which ratios best separated failed companies from healthy ones. He found that a weighted combination of five ratios predicted failure well.
The weights reflect how strongly each ratio differentiated the two groups. The five ratios cover liquidity, accumulated profitability, earnings power, financial leverage and asset efficiency.
They are working capital to total assets, retained earnings to total assets, EBIT (earnings before interest and tax) to total assets, market value of equity to total liabilities, and sales to total assets. Each is multiplied by a weight and the results are added up.
For the original model aimed at listed manufacturers, a score above about 2.99 is considered safe, a score between about 1.81 and 2.99 is a grey zone, and a score below 1.81 suggests distress. Altman later created versions for private companies and for non-manufacturers with different weights and cut-offs.
It is important to use the version that fits the type of business. The score is a useful screen, not a verdict.
Companies in the grey zone are not doomed, and companies in the safe zone can still fail, particularly through fraud or sudden shocks. Analysts use it alongside cash flow analysis, covenant tests and judgement about the industry.
Because it relies on accounting data, the model is only as reliable as the numbers. Aggressive accounting can inflate retained earnings or earnings, and the market value of equity in the fourth ratio moves with share prices.
Tracking the score over several periods reveals whether a business is improving or deteriorating. The variables are worth understanding because they tell a story.
Retained earnings to total assets shows how much of the business has been financed by past profits rather than borrowing, and a young company naturally scores lower here. Market value of equity to liabilities adds the market's opinion, which makes the score respond quickly when investors lose confidence.
In practice
Real-world examples
Example 1
A bank assesses a loan request from a manufacturer and calculates a Z score of 1.5. The distress-zone score prompts the bank to ask for additional security and a repayment schedule tied to cash flow, instead of declining outright.
Example 2
A fund manager screens a list of listed companies and removes those with scores below 1.81. The screen reduces the chance of holding a company that is heading for trouble. The manager then examines the remaining names in detail, looking at cash flow and debt maturities.
Example 3
A supplier uses the score to decide how much credit to give a new customer. A score of 3.4 supports a generous credit limit, while a score of 2.0 leads to shorter payment terms and a lower limit.
Think of it
The Altman Z-Score is like a credit score for companies. Higher scores mean lower risk of default; lower scores raise red flags.
Formula
Calculation
Z = 1.2 x X1 + 1.4 x X2 + 3.3 x X3 + 0.6 x X4 + 1.0 x X5
Where X1 = Working capital / Total assets, X2 = Retained earnings / Total assets, X3 = EBIT / Total assets, X4 = Market value of equity / Total liabilities, X5 = Sales / Total assets.
A listed manufacturer has total assets of $10,000,000, working capital of $2,000,000, retained earnings of $3,000,000, EBIT of $1,000,000, market value of equity of $6,000,000, total liabilities of $5,000,000 and sales of $12,000,000. The ratios are X1 = 0.2, X2 = 0.3, X3 = 0.1, X4 = 1.2 and X5 = 1.2. Z = (1.2 x 0.2) + (1.4 x 0.3) + (3.3 x 0.1) + (0.6 x 1.2) + (1.0 x 1.2) = 0.24 + 0.42 + 0.33 + 0.72 + 1.20 = 2.91. The score sits in the grey zone, just below the safe threshold.Case study
Seen in the real world
Copperfield Steel is a fictional manufacturer that, in this illustrative story, reported rising sales but falling profits for three consecutive years. A credit analyst at its main lender recalculated the Z score each year.
The score fell from 3.2 to 2.6 and then to 1.7 as retained earnings shrank and borrowing rose. In the third year the score entered the distress zone, even though the company still met its loan payments.
The lender met the management team and agreed a recovery plan with tighter cost controls and asset sales. Two years later the score recovered to 2.4, and the lender relaxed its covenants. The analyst kept the annual calculation in the credit file.
Watch out
Common mistakes
- Using the original model for banks, service firms or private companies. Different versions exist, and the cut-offs differ.
- Treating the score as a guarantee. It estimates risk, but it cannot predict every failure.
- Calculating it once and forgetting it. The trend over several periods is more informative.
Questions
People also ask
What does a Z score of 2.5 mean?
In the original model it sits in the grey zone, between 1.81 and 2.99. The company is not clearly safe or clearly distressed, so further analysis is needed.
Who created the Altman Z score?
Edward Altman, a finance professor, introduced it in the late 1960s. He later published revised versions for different company types.
Is a low score the same as bankruptcy?
No. It signals higher risk, but many companies with low scores recover. Management action and fresh funding can change the outlook, so analysts look at the direction of travel as well as the level.
Watch