Altman Z-score

What it means

The Altman Z-score was devised by the American economist Edward Altman in the late 1960s, when he was looking for a way to predict corporate bankruptcy from readily available accounting figures. The model combines five financial ratios with fixed weights into one number, which is compared with threshold zones.

The ratios capture different aspects of a company’s health: working capital to total assets, retained earnings to assets, EBIT to assets, the value of equity to liabilities, and sales to assets.

The result falls into one of three zones: safe, grey and distress. The original model was built for listed manufacturing companies; for private and non-manufacturing firms there are adjusted versions with different weights and cut-offs.

How it works in practice

In practice the Z-score works as a quick signal within broader financial analysis. Banks use it when assessing creditworthiness, suppliers when setting credit limits, and auditors when judging whether a company can continue as a going concern.

For our clients we calculate it from several years of accounts in a row, because one number says little whereas a falling trend is a warning. When a company approaches the distress zone we also compare the result with the statutory criteria used to assess whether the company is in crisis.

The Z-score is sensitive to accounting choices such as capitalisation, revaluation of assets or the creation of provisions. When comparing two companies we therefore also look at how they account, so that a difference in scores is not merely a difference in accounting policy.

What to watch out for

The Z-score does not replace the statutory test. Whether a company is in crisis or insolvent is decided by the ratio of equity to liabilities, over-indebtedness and inability to pay, not by the model. Even a company in the safe zone can be unable to pay if it runs out of cash.

The biggest mistake is ignoring the signal. When the score falls several years running, it is time to deal with financing, costs or preventive restructuring before the director becomes obliged to file for bankruptcy and liable for filing late.