Altman Z Score Formula
/What is the Altman Z Score?
The Altman Z Score is used to predict the likelihood that a business will go bankrupt within the next two years. It was developed and first published by Edward Altman in 1968.
The Z score formula is based on information found in the income statement and balance sheet of an organization; as such, it can be readily derived from commonly-available information. The Z score is based on the liquidity, profitability, solvency, sales activity, and leverage of the targeted business. Given the ease with which the required information can be found, the Z Score is a useful metric for an outsider who has access to a company's financial statements.
How to Calculate the Altman Z Score
In its original form, the Z score formula is as follows:
Z = 1.2A + 1.4B + 3.3C + 0.6D + 0.99E
The letters in the formula designate the following measures:
A = Working capital / Total assets [ Measures the relative amount of liquid assets]
B = Retained earnings / Total assets [Determines cumulative profitability]
C = Earnings before interest and taxes / Total assets [measures earnings away from the effects of taxes and leverage]
D = Market value of equity / Book value of total liabilities [incorporates the effects of a decline in market value of a company's shares]
E = Sales / Total assets [measures asset turnover]
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Understanding the Altman Z Score
A Z score of greater than 2.99 means that the entity being measured is safe from bankruptcy. A score of less than 1.81 means that a business is at considerable risk of going into bankruptcy, while scores in between should be considered a red flag for possible problems. The model has proven to be reasonably accurate in predicting the future bankruptcy of entities under analysis.
This scoring system was originally designed for manufacturing firms having assets of $1 million or more. Given the targeted nature of the model, it has since been modified to be applicable to other types of organizations.
Example of the Altman Z Score
As an example of the Altman Z score, a company has the following financial information:
Working capital: $500,000
Retained earnings: $1,000,000
EBIT: $750,000
Total assets: $5,000,000
Market value of equity: $2,000,000
Total liabilities: $3,000,000
Sales: $4,000,000
A step-by-step calculation of the Altman Z score is as follows:
A = 500,000 ÷ 5,000,000 = 0.10
B = 1,000,000 ÷ 5,000,000 = 0.2
C = 750,000 ÷ 5,000,000 = 0.15
D = 2,000,000 ÷ 3,000,000 = 0.6667
E = 4,000,000 ÷ 5,000,000 = 0.80
We then plug these outcomes into the Altman Z score formula, as noted below:
(1.2)(0.10) + (1.4)(0.20) + (3.3)(0.15) + (0.6)(0.6667) + (1.0)(0.80) = Z score of 2.095
A Z score of 2.095 puts the company in a gray zone, indicating that it is at moderate risk of financial distress.
Advantages of the Altman Z Score
This approach to evaluating organizations is better than using just a single ratio, since it brings together the effects of multiple items - assets, profits, and market value. As such, it is most commonly used by creditors and lenders to determine the risk associated with extending funds to customers and borrowers.