What is the Altman Z-Score?

The Altman Z-Score is a multifaceted metric designed to assess the creditworthiness of companies. It is based on five key financial ratios derived from a company’s annual 10-K report. These ratios collectively measure profitability, leverage, liquidity, solvency, and activity—essential attributes that reflect a company’s overall financial health.

Components of the Altman Z-Score

Working Capital / Total Assets (X1)

The first component calculates Working Capital (Current Assets – Current Liabilities) divided by Total Assets. This ratio provides insight into a company’s short-term liquidity, indicating its ability to meet immediate obligations.

Retained Earnings / Total Assets (X2)

This component measures Retained Earnings relative to Total Assets. It reflects the accumulated profits over time and how they compare to the company’s asset base, giving an idea of long-term profitability.

Earnings Before Interest and Tax (EBIT) / Total Assets (X3)

Here, EBIT is divided by Total Assets. This ratio assesses the profitability of a company’s assets, showing how efficiently assets are being used to generate earnings.

Market Value of Equity / Total Liabilities (X4)

This component compares the Market Value of Equity to Total Liabilities. It indicates how well the company’s market value covers its liabilities, providing a snapshot of its solvency.

Sales / Total Assets (X5)

The final component calculates Sales divided by Total Assets. This efficiency ratio measures asset productivity, showing how effectively assets are being utilized to generate sales.

How to Calculate the Altman Z-Score

To calculate the Altman Z-Score, you use the following formula:

Altman Z-Score = 1.2(X1) + 1.4(X2) + 3.3(X3) + 0.6(X4) + 1.0(X5)

Here’s a step-by-step example using hypothetical company data:
– Assume X1 = 0.15, X2 = 0.20, X3 = 0.10, X4 = 1.50, and X5 = 0.80.
– Plug these values into the formula:

Altman Z-Score = 1.2(0.15) + 1.4(0.20) + 3.3(0.10) + 0.6(1.50) + 1.0(0.80)


Altman Z-Score = 0.18 + 0.28 + 0.33 + 0.90 + 0.80


Altman Z-Score = 2.39


Interpreting the Altman Z-Score

Distress Zone

A Z-Score below 1.8 indicates that a company is in the distress zone, suggesting a high risk of bankruptcy.

Caution Zone

A Z-Score between 1.8 and 2.99 (or 3.0) places the company in a cautionary zone, where financial health is questionable but not critically poor.

Safe Zone

A Z-Score above 3.0 signifies good financial health and low risk of bankruptcy.

Variations of the Altman Z-Score

Over time, variations of the original Altman Z-Score have been developed to accommodate different types of companies:
– The Altman Z-Score Plus is an updated version.
– Formulas for private companies, non-manufacturing companies, and emerging markets companies have also been developed to ensure broader applicability.

Accuracy and Limitations

The Altman Z-Score has shown significant accuracy in predicting bankruptcies with a success rate of 80-90% one year prior to bankruptcy. However, it is not without limitations:
– It can be vulnerable to false accounting practices.
– It may not be applicable to new companies with little or no earnings history.

Practical Applications and Examples

The Altman Z-Score has been used in various real-world scenarios:
– For instance, analyzing WorldCom before its bankruptcy could have provided early warning signs using this metric.
– Investors can use the Altman Z-Score to screen for bankruptcy risk and make informed investment decisions.