How do I calculate and interpret the Altman Z-score?

Question

AcadiFi · Accepted Answer

Edward Altman's original 1968 Z-score uses five ratios from public manufacturing firms:

Z = 1.2·X1 + 1.4·X2 + 3.3·X3 + 0.6·X4 + 1.0·X5

Where:
- X1 = Working Capital / Total Assets (liquidity)
- X2 = Retained Earnings / Total Assets (cumulative profitability)
- X3 = EBIT / Total Assets (operating efficiency)
- X4 = Market Value of Equity / Book Value of Total Liabilities (leverage)
- X5 = Sales / Total Assets (asset turnover)

Example: Orillion Steel Corp has $80M working capital, $1.2B total assets, $240M retained earnings, $90M EBIT, $900M market cap, $600M total liabilities, $1.5B sales.

- X1 = 80/1200 = 0.067 → 0.080
- X2 = 240/1200 = 0.200 → 0.280
- X3 = 90/1200 = 0.075 → 0.248
- X4 = 900/600 = 1.500 → 0.900
- X5 = 1500/1200 = 1.250 → 1.250

Z = 0.080 + 0.280 + 0.248 + 0.900 + 1.250 = 2.76

Interpretation zones:
- Z > 2.99 → 'Safe' zone (low default risk)
- 1.81 < Z < 2.99 → 'Grey' zone (uncertain)
- Z < 1.81 → 'Distress' zone (high default risk)

Orillion at 2.76 sits in the grey zone — monitor closely.

Altman later published Z' (private firms, using book equity) and Z'' (non-manufacturers and emerging markets). For FRM, know that Z-score is a discriminant analysis model — it's historical, linear, and does not capture macro conditions. Modern replacements include KMV's structural model and machine-learning PD models.

How do I calculate and interpret the Altman Z-score?

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