How to Calculate the Altman Z-Score: Formula and Steps

The Altman Z-score is a widely recognized financial tool designed to assess a company’s financial health and predict its likelihood of experiencing financial distress or bankruptcy. This score provides a quantitative measure of a company’s solvency and stability. It offers an early warning system, enabling investors, creditors, and analysts to evaluate potential risks associated with a company’s financial standing. The model combines various financial ratios into a single score, offering a comprehensive view rather than relying on individual metrics.

Understanding the Altman Z-Score

The Altman Z-score is a multivariate formula that uses a company’s financial ratios to forecast the probability of corporate bankruptcy. It indicates the financial stability of an organization, particularly for publicly traded manufacturing companies for which the original model was designed. Investors frequently use this score to inform decisions regarding stock purchases or sales, depending on the company’s financial strength.

Creditors rely on the Z-score to gauge a borrower’s creditworthiness before extending loans, while business analysts employ it for risk assessment and due diligence. While several versions of the Z-score exist for different company types, such as private or non-manufacturing firms, this discussion focuses on the original model applicable to public companies.

Required Financial Data

Calculating the Altman Z-score necessitates specific financial data points, primarily sourced from a company’s audited financial statements: the Balance Sheet and the Income Statement. Gather figures for Working Capital, Retained Earnings, Earnings Before Interest and Taxes (EBIT), Market Value of Equity, Book Value of Total Liabilities, and Sales. Total Assets will also be needed for several ratios.

Working Capital, found on the Balance Sheet, is current assets minus current liabilities, indicating short-term liquidity. Retained Earnings, located in the shareholders’ equity section of the Balance Sheet, represents cumulative net income a company has kept after paying dividends. Earnings Before Interest and Taxes (EBIT) is operating income on the Income Statement, reflecting profitability before interest and taxes.

Market Value of Equity is derived by multiplying the current share price by the total number of outstanding shares. Book Value of Total Liabilities is a direct line item on the Balance Sheet, representing all financial obligations owed by the company. Sales, often labeled as Revenue, is the top line item on the Income Statement, indicating total income generated from goods sold or services provided. Total Assets is a summary figure on the Balance Sheet, representing all economic resources owned by the company.

Steps to Calculate the Z-Score

With the necessary financial data, the Altman Z-score calculation proceeds in two stages: computing individual ratios and then combining them into the final formula. There are five distinct ratios, each contributing to the overall score. The first ratio (A) measures liquidity by dividing Working Capital by Total Assets. For example, if a company has $50 million in working capital and $200 million in total assets, Ratio A is 0.25 ($50M / $200M).

The second ratio (B) assesses cumulative profitability by dividing Retained Earnings by Total Assets. If a company has $75 million in retained earnings and $200 million in total assets, Ratio B is 0.375 ($75M / $200M). The third ratio (C) indicates operating efficiency by dividing Earnings Before Interest and Taxes (EBIT) by Total Assets. If EBIT is $40 million and total assets are $200 million, Ratio C is 0.20 ($40M / $200M).

The fourth ratio (D) considers market valuation relative to debt, by dividing Market Value of Equity by Book Value of Total Liabilities. If the market value of equity is $150 million and total liabilities are $100 million, Ratio D is 1.5 ($150M / $100M). The final ratio (E) reflects asset turnover efficiency, by dividing Sales by Total Assets. If sales are $300 million and total assets are $200 million, Ratio E is 1.5 ($300M / $200M).

Once these five ratios (A, B, C, D, E) are calculated, they are plugged into the Altman Z-score formula: Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E. Using the example figures, the calculation is Z = (1.2 0.25) + (1.4 0.375) + (3.3 0.20) + (0.6 1.5) + (1.0 1.5). This results in Z = 0.3 + 0.525 + 0.66 + 0.9 + 1.5, yielding a final Z-score of 3.885.

Interpreting Your Z-Score Result

After calculating the Altman Z-score, the resulting number falls into one of three distinct zones, each indicating a different level of financial health and bankruptcy probability. A Z-score greater than 2.99 places a company in the “Safe Zone.” Companies within this range are considered in a sound financial position with a low likelihood of bankruptcy.

A Z-score falling between 1.81 and 2.99 is known as the “Gray Zone.” This range suggests a moderate risk of financial distress. While bankruptcy is not imminent, the company might face underlying financial challenges. Companies in the gray zone warrant closer monitoring and further analysis.

Conversely, a Z-score less than 1.81 signifies the “Distress Zone.” This score indicates a high probability of financial distress and significant bankruptcy risk within two years. While the Altman Z-score is a powerful predictive model, it serves as an indicator and not a definitive guarantee of a company’s future.