Altman Z-Score

The Altman Z-Score is an empirical model that predicts the probability of corporate bankruptcy. This article introduces this valuable predictor of financial distress, and offers a calculation spreadsheet.

The Altman Z-Score was published in 1968 by Edward Altman, and measures a company’s financial heatlth. He chose 66 publicly-traded manufacturing companies (half of which had declared bankruptcy, and half of which had not). Altman then examined several common financial ratios based on data retrieved from annual financial reports. After linearly combining these ratios, Altman arrived at an empirical equation (called the the Z-Score) that predicted the risk of corporate failure within two years with an accuracy of 72%, and false-positives at 6%

This equation was also tested against companies not in the initial sample. The equation predicted bankruptcy or non-bankruptcy to within a high degree of accuracy.

Altman later published modification called the Z1-Score, which can be applied to privately-held manufacturing companies, and Z2-score for non-manufacturing companies.

The value of the Z-Score indicates the health of a company, with a higher value being better. The equations use the following financial information.

• Working Capital
• Total Assets
• Retained Earnings
• Earnings Before Tax and Interest, or EBIT
• Market Value of Equity (for publicly-traded companies
• Book Value or Net Worth (for privately-end companies)
• Total Liabilities
• Sales

These quantities are combined into the follows ratios

• X1 = Working Capital / Total Assets (measures liquidity)
• X2 = Retained Assets / Total Assets
• X3 = Earnings Before Tax and Interest / Total Assets (measures how effectively the company uses its assets to get return)
• X4 = Market Value of Equity / Total Liabilities (measures the market’s view of the company’s health)
• X4A = Book Value / Total Liabilties
• X5 = Sales / Total Assets (indicated asset turnover)

The Z-score is then a linear combination of these ratios as follows

• Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5
• Z1 = 0.717 X1 + 0.847 X2 + 3.107 X3 + 0.42 X4A + 0.998 X5
• Z2 = 6.56 X1 + 3.26 X2 + 6.72 X3 + 1.05 X4A

The latter two equations are often referred to as Altman model A (for private manufacturing firms) and model B (for general firms). The bands and typical values for the Z-Score are as follows.

The Z-Score is still widely used primarily because of its simplicity and the ease with which the financial data is obtained. However, Shumway (2001) demonstrated than several of the parameters use in the Z-score equations now do not adequately predict bankruptcy, and identified a better predictive model. Chava and Jarrow (2004) confirmed that the Shumway (2001) model is a better predictor of financial distress.

4 thoughts on “Altman Z-Score”

1. Mike says:

Hello,

I am using the Z Score calculator but the Z score seems to be very high. When I enter in the data all is fine until I add market value of equity, then the Z score goes through the roof. Could you email me an example of Apple Inc so I can use your example to aid me?

Thanks,
Mike Gaboury

2. Ephrem G. says:

hello, Mr. Samir

I really appreciate your effort to help people who are using Altman’s Z score do their job easily.
I am now conducting a research work in financial institutions of Ethiopia using this model especially the Z2 Score which is supposed to be for non manufacturing firms. I hope your “calculator” will help me a lot. And I am very grateful for your support.

But I have only one question; is there any way to access the “new” ZETA model with Seven variable which Dr. Altman had developed by revisiting the “old” Z score. I would be very pleased if can help me to find it. And thanks in advance for your help. i look forward from you.

Thanks

Ephrem G.

3. Hi Samir

Thanks for a great intro re Altman Z score. I’ve recently been introduced to the score through my work with profitguardian and other software and now have additional leads to follow re Shumway and the ZETA model.

One observation/question – the ‘Bands for z score’ summary above notes an average score for bankrupt companies of 4.06. Is this a typo? If not then how does that result correlate to the parameters for indicating entity health i.e. 3 and 1.8, 2.6 & 1.1? A score of 4 would have those bankrupt entities noted as healthy wouldn’t it?