Altman Z-Score
The Altman Z-Score predicts the probability of a company going bankrupt within 2 years using five financial ratios.
Includes formula and worked examples.
The Formula
Interpretation: Z > 2.99 → Safe zone 1.81 ≤ Z ≤ 2.99 → Grey zone Z < 1.81 → Distress zone (high bankruptcy risk)
The Altman Z-Score was developed by New York University finance professor Edward Altman in 1968. By combining five financial ratios into a single score, it estimates how likely a publicly traded manufacturing company is to go bankrupt within the next two years. In Altman's original research, the model correctly classified 72% of companies as bankrupt or solvent up to two years before the event.
The formula was groundbreaking because it replaced subjective credit judgments with an objective, quantitative tool. Banks, investors, and credit analysts still use it today — more than 50 years after its creation — as a quick screening tool before committing to loans or equity positions.
Note that the original formula was designed for publicly traded manufacturers. Altman later developed modified versions for private companies (Z-score Prime) and non-manufacturing firms (Z-score double-prime). Always match the correct version to the type of company being analyzed.
Variables
| Symbol | Meaning | Unit |
|---|---|---|
| X₁ | Working Capital / Total Assets — measures short-term liquidity | ratio |
| X₂ | Retained Earnings / Total Assets — measures accumulated profitability | ratio |
| X₃ | EBIT / Total Assets — measures operating efficiency | ratio |
| X₄ | Market Value of Equity / Total Liabilities — measures leverage (publicly traded firms) | ratio |
| X₅ | Sales / Total Assets — measures asset turnover efficiency | ratio |
| Z | Final Z-Score — the bankruptcy risk indicator | dimensionless |
Example 1
A manufacturing company has: Working Capital = $200M, Retained Earnings = $150M, EBIT = $80M, Market Equity = $400M, Total Liabilities = $300M, Sales = $900M, Total Assets = $700M.
X₁ = 200/700 = 0.286
X₂ = 150/700 = 0.214
X₃ = 80/700 = 0.114
X₄ = 400/300 = 1.333
X₅ = 900/700 = 1.286
Z = 1.2×0.286 + 1.4×0.214 + 3.3×0.114 + 0.6×1.333 + 1.0×1.286
Z = 0.343 + 0.300 + 0.376 + 0.800 + 1.286 = 3.105
Z = 3.105 — Safe zone (Z > 2.99). Low bankruptcy risk.
Example 2
A struggling company has: Working Capital = −$50M, Retained Earnings = −$30M, EBIT = $10M, Market Equity = $80M, Total Liabilities = $500M, Sales = $600M, Total Assets = $550M.
X₁ = −50/550 = −0.091
X₂ = −30/550 = −0.055
X₃ = 10/550 = 0.018
X₄ = 80/500 = 0.160
X₅ = 600/550 = 1.091
Z = 1.2×(−0.091) + 1.4×(−0.055) + 3.3×0.018 + 0.6×0.160 + 1.0×1.091
Z = −0.109 − 0.077 + 0.059 + 0.096 + 1.091 = 1.060
Z = 1.060 — Distress zone (Z < 1.81). High bankruptcy risk — a major warning sign for investors and lenders.
When to Use It
Use the Altman Z-Score when:
- Screening publicly traded manufacturing companies for bankruptcy risk before investing
- Evaluating a borrower's creditworthiness before extending a loan
- Monitoring an existing portfolio for companies showing signs of financial distress
- Benchmarking a company against its industry peers on financial health
- Combining with other metrics such as the Sharpe Ratio and CAPM for full investment analysis