Altman Z-Score

A credit-strength test that uses five financial ratios to predict the probability of a company going bankrupt within two years.

The Altman Z-Score is a multi-factor financial formula used to evaluate a company's credit strength and predict its likelihood of entering bankruptcy within a two-year period. Developed by NYU Stern Professor Edward Altman in 1968, the model combines five distinct balance sheet and income statement ratios into a single numerical score. These ratios assess liquidity, cumulative profitability, productivity of assets, leverage, and asset turnover. To calculate the score, each of the five ratios is multiplied by a specific weight and then summed. For publicly traded manufacturing companies, the traditional formula uses weights optimized to detect distress. The resulting score places the company into one of three zones: the Safe Zone (score above 3.0), the Grey Zone (score between 1.81 and 3.0), or the Red Zone (score below 1.81), which indicates a high probability of bankruptcy. Investors use the Altman Z-Score as a screening tool to avoid high-risk equities or to evaluate the creditworthiness of corporate bond issuers. While highly reliable historically, the traditional formula has limitations. It was originally designed for manufacturing firms with physical assets and inventories, making it less accurate for modern technology, service, or financial companies. Additionally, because it relies on historical accounting data, it can be a lagging indicator if a company's financial condition is deteriorating rapidly.

Company A has the following financial metrics: Working Capital = $10M, Retained Earnings = $20M, EBIT = $15M, Market Value of Equity = $50M, Sales = $80M, Total Assets = $100M, and Total Liabilities = $40M. First, calculate the five ratios: A (Working Capital / Total Assets) = 10 / 100 = 0.10 B (Retained Earnings / Total Assets) = 20 / 100 = 0.20 C (EBIT / Total Assets) = 15 / 100 = 0.15 D (Market Value of Equity / Total Liabilities) = 50 / 40 = 1.25 E (Sales / Total Assets) = 80 / 100 = 0.80 Next, apply the weights: Z = (1.2 0.10) + (1.4 0.20) + (3.3 0.15) + (0.6 1.25) + (0.99 0.80) Z = 0.12 + 0.28 + 0.495 + 0.75 + 0.792 = 2.437 With a Z-Score of 2.44, Company A falls into the 'Grey Zone' (between 1.81 and 3.0), indicating moderate default risk.