Altman Z-Score

The Altman Z-Score combines five financial ratios to assess whether a company may face financial distress.

• Edward Altman introduced the original model in 1968.
• The original formula was designed mainly for publicly traded manufacturing companies.
• It uses working capital, retained earnings, EBIT, market value of equity, sales, total assets, and total liabilities.
• A score below 1.81 indicates financial distress.
• A score between 1.81 and 2.99 falls in the grey zone.
• A score above 2.99 generally indicates a lower risk of bankruptcy.
• Different formulas are available for private, non-manufacturing, and emerging-market companies.
• The score should be used with cash flow analysis, ratio analysis, and industry comparisons.
   

The Altman Z-Score is a formula-based measure that evaluates a company’s financial stability using five financial ratios.
These ratios consider working capital, retained earnings, earnings before interest and tax, market value of equity, sales, total assets, and total liabilities.
The original model was mainly created to assess publicly traded manufacturing companies and identify possible financial distress within two years. However, a high or low score should not be treated as a guarantee that bankruptcy will or will not occur.
 

The following financial values are used to calculate the Altman Z-Score:

For example, if a company has current assets of ₹8 lakh and current liabilities of ₹5 lakh, its working capital is ₹3 lakh.

The original Altman Z-Score formula for publicly traded manufacturing companies uses five ratios.

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

Where:

• A = Working capital ÷ Total assets
• B = Retained earnings ÷ Total assets
• C = EBIT ÷ Total assets
• D = Market value of equity ÷ Total liabilities
• E = Sales ÷ Total assets

Each ratio measures a different part of the company’s financial position, such as liquidity, profitability, solvency, and asset efficiency.

Consider a hypothetical company with the following financial information:

The five ratios will be calculated as follows:

Now, place these values in the formula:

Altman Z-Score

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

= 1.2(0.25) + 1.4(0.15) + 3.3(0.125) + 0.6(1.5) + 1.0(1.5)

= 0.30 + 0.21 + 0.4125 + 0.90 + 1.50

= 3.3225

Based on the original model’s score ranges, this company falls in the safe zone. However, the score should still be considered along with other financial information.

After calculating the Altman Z-Score, you can compare the result with the ranges used for publicly traded manufacturing companies.

These ranges are warning indicators rather than guarantees. A company in the safe zone may still face financial problems, while a company in the distress zone may recover.

The original model was designed for publicly traded manufacturing companies. Modified versions were later developed for private manufacturing businesses, non-manufacturing companies, and companies operating in emerging markets.

1. Private manufacturing companies

For private manufacturing companies, the formula uses the book value of equity instead of the market value of equity.

Altman Z-Score = 0.717A + 0.847B + 3.107C + 0.42D + 0.998E

Where:

A = Working capital ÷ Total assets

B = Retained earnings ÷ Total assets

C = EBIT ÷ Total assets

D = Book value of equity ÷ Total liabilities

E = Sales ÷ Total assets

2. Non-manufacturing companies in developed markets

For non-manufacturing companies, the sales-to-total-assets ratio is removed because asset turnover can differ greatly across industries.

Altman Z-Score = 6.56A + 3.26B + 6.72C + 1.05D

Where:

A = Working capital ÷ Total assets

B = Retained earnings ÷ Total assets

C = EBIT ÷ Total assets

D = Book value of equity ÷ Total liabilities

3. Non-manufacturing companies in emerging markets

The emerging-market version adds a constant of 3.25 to the non-manufacturing formula.

Altman Z-Score = 3.25 + 6.56A + 3.26B + 6.72C + 1.05D

Where:

A = Working capital ÷ Total assets

B = Retained earnings ÷ Total assets

C = EBIT ÷ Total assets

D = Book value of equity ÷ Total liabilities

The correct model should be selected based on whether the company is public or private, manufacturing or non-manufacturing, and operating in a developed or emerging market.

The original Altman Z-Score uses five ratios. Together, they provide a broader view of the company’s liquidity, profitability, solvency, and operating efficiency.

1. Working capital to total assets

Working capital is calculated by subtracting current liabilities from current assets.

The working-capital-to-total-assets ratio measures whether a company has enough short-term resources to meet its short-term obligations.

For example, a company with current assets of ₹10 lakh and current liabilities of ₹7 lakh has positive working capital of ₹3 lakh.

A positive ratio generally indicates better short-term liquidity. A negative ratio may suggest that the company could have difficulty meeting obligations due within a year.

2. Retained earnings to total assets

Retained earnings are the cumulative profits kept in the business after losses and dividend payments.

The retained-earnings-to-total-assets ratio shows how much of the company’s assets have been financed using profits retained over time.

A low ratio may indicate that the company is relatively new, has accumulated losses, distributes a large part of its profits, or depends more heavily on external funding. A higher ratio generally indicates stronger accumulated profitability.

3. EBIT to total assets

EBIT means earnings before interest and tax. It represents the profit generated from business operations before financing costs and taxes are considered.

The EBIT-to-total-assets ratio measures how efficiently a company uses its assets to generate operating profit.

For example, two companies may each own assets worth ₹20 lakh. If one generates EBIT of ₹4 lakh and the other generates ₹1 lakh, the first company uses its assets more profitably.

4. Market value of equity to total liabilities

The market value of equity is calculated by multiplying the company’s outstanding shares by its current share price.

The market-value-of-equity-to-total-liabilities ratio compares the market value held by shareholders with the company’s total financial obligations.

A higher ratio generally means the company has a larger market-value cushion relative to its liabilities. However, the ratio can change when the company’s share price moves.

5. Sales to total assets

The sales-to-total-assets ratio measures how efficiently a company uses its assets to generate revenue. It is also known as the asset turnover ratio.

A higher ratio generally means the company generates more sales for each rupee invested in assets.

However, the ratio can differ significantly across industries. A retail business may naturally have a higher asset turnover than a capital-intensive manufacturing company.

The Altman Z-Score can help identify signs of financial distress, but it should not be used as the only measure of a company’s financial health.

1. It relies heavily on past data

The model uses information from financial statements, which mainly reflects the company’s past performance.

If the business has experienced major changes after the reporting date, the score may not fully show its current financial condition.

2. It cannot predict the exact timing of bankruptcy

The score places a company in a financial-risk zone, but it does not tell you the exact date on which bankruptcy may occur.

It also does not provide a guaranteed probability that a company will fail. It should be treated as an early warning indicator.

3. It may not reflect unusual business models

Some financially stable businesses regularly operate with negative working capital.

For example, a retailer may collect cash from customers immediately but pay suppliers several weeks later. This business structure may reduce its working-capital ratio without necessarily indicating insolvency.

4. It may not suit early-stage businesses

Early-stage companies may have low retained earnings, limited operating profits, or accumulated losses because they are still investing in growth.

As a result, their Z-Scores may appear weak even when they have access to funding and a viable long-term business plan.

The original model is also not generally considered suitable for financial institutions such as banks and insurers because their balance sheets and use of leverage differ from those of manufacturing companies.

The Altman Z-Score helps you assess a company’s financial health by combining several important ratios into one score. However, it should not be considered a definite prediction of bankruptcy.
To form a more complete view, you should also consider cash flow analysis, financial ratio trends, debt levels, industry conditions, and comparisons with similar companies. Using these methods together can provide a clearer understanding of a company’s financial strength and creditworthiness.