Lesson 6 of 7
The Altman Z-Score as a tool
The Altman Z-Score folds five ratios into one number, fitted to separate bankrupt manufacturers from healthy ones. It was never fitted on banks.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The Z-Score adds five weighted ratios into one number, built in 1968 to separate manufacturers that went bankrupt from ones that did not.
- The zones commonly quoted put a Z above 2.99 in the safe range, below 1.81 in the distressed range, and the band between in a grey zone.
- It was fitted on public manufacturers, and it reads oddly on banks, utilities and asset-light service companies, whose balance sheets look nothing like the sample it was built on.
The Z-Score is five ordinary ratios, each already computable from a company's own statements. Altman combined them into one number, with weights fitted so that number separated his sample of failed and healthy manufacturers as cleanly as possible.
Building one company's Z-Score from its five terms
- X1: working capital ÷ assets, weighted 1.2×0.12
- X2: retained earnings ÷ assets, weighted 1.4×+0.28
- X3: EBIT ÷ assets, weighted 3.3×+0.33
- X4: market value of equity ÷ liabilities, weighted 0.6×+0.60
- X5: sales ÷ assets, weighted 1.0×+1.20
- Z-Score= 2.53
Five ratios, one score
Each of the five inputs proxies for a different way a company can be in trouble, and Altman weighted each one by how much it separated his sample of failed and non-failed companies.
| Term | Ratio | What it proxies for |
|---|---|---|
| X1 | Working capital ÷ total assets | Short-term liquidity |
| X2 | Retained earnings ÷ total assets | How much of the balance sheet is built from earnings kept over the company's life |
| X3 | EBIT ÷ total assets | Operating profitability |
| X4 | Market value of equity ÷ total liabilities | How far the market's own value of the equity would have to fall before liabilities exceeded it |
| X5 | Sales ÷ total assets | How hard the assets are working |
The zones commonly quoted
The zones commonly quoted from Altman's 1968 model put a score above 2.99 in the safe range and below 1.81 in the distressed range. The band between is called the grey zone, where failed and healthy companies overlapped. A Z of 2.53 sits inside it.
What it was never fitted on
Altman built the Z-Score on public manufacturing companies, and applying its weights outside that group is a different question, not a smaller version of the same one, as the prerequisite lesson on fitted scores sets out in general. Two of the five terms carry a further catch worth knowing on their own: X4 uses the market value of equity, so the score moves on days the accounts do not change at all, and X2 marks a young company down simply for being young, since it has had less time to build retained earnings.
Check yourself
A company scores a Z of 2.53. Where does that sit against Altman's original zones?
- In the safe zone, above 2.99
- In the grey zone, between 1.81 and 2.99
- In the distress zone, below 1.81
Show the answer
Answer: B.
The grey zone commonly quoted from Altman's 1968 model runs between 1.81 and 2.99. A score of 2.53 falls inside it, neither his clearest safe reading nor his clearest distress one.Why does the Z-Score read oddly on a bank?
- Banks never have working capital
- The model was fitted on public manufacturers, whose balance sheets of plant and inventory look nothing like a bank's deposits and loans
- Banks carry too little debt for the score
Show the answer
Answer: B.
Altman fitted the Z-Score's weights on manufacturing companies. Applying the same weights to a bank's very different balance sheet is a different question from the one the model was built to answer.What does the X4 term, market value of equity over total liabilities, proxy for?
- How efficiently assets generate sales
- How far the market's own value of the equity would have to fall before liabilities exceeded it
- How much of the balance sheet is retained earnings
Show the answer
Answer: B.
X4 compares the market's own value of the equity cushion against total liabilities, one market-based view of how much room the company has before it is technically insolvent.Sources
- Altman, Journal of Finance, 1968: the Z-Score, fitted on public manufacturers; zones at 1.81 and 2.99.
What this leaves out
- The weights and zone boundaries are Altman's 1968 originals; several later variants exist for private and non-manufacturing companies and are not this lesson's subject.
- The worked example uses round invented ratios chosen so the five contributions sum exactly to the total shown.
- A Z-Score is a statistical pattern fitted on one historical sample, not a forecast for any specific company. It is not advice about any security.