Altman z-score is a statistic that measures the credit risk of a company. Companies with z-score of less than 1.81 are prone to bankruptcy. Z-score equals 1.2 times the working capital to total assets, 1.4 times retained earnings to total assets, 3.3 times EBIT to total assets, 0.6 times market capitalization to book value of liabilities and 1 time the total asset turnover.
The z-score is based on historical analysis aimed at identifying which ratios are a good predictor of financial distress. The original model as discussed below is applicable to manufacturing entities. However, modified models have been created to apply the z-score to private companies and non-manufacturing companies.
The Altman z-score is not to be confused with z-score (which is commonly referred to as z-statistic) used in statistics which calculates the number of standard deviation that an observation is away from mean.
Following is the formula for Altman z-score:
$$ Z\ Score\\=1.2\times WC/A\\+1.4\times RE/A\\+3.3\times EBIT/A\\+0.6\times MC/L\\+1\times TAT $$
Where WC/A is the working capital to total assets ratio, RE/A is the retained earnings to total assets ratio, EBIT/A is the earning before interest and taxes (EBIT) to total assets ratio, MC/L is the market capitalization to liabilities ratio and TAT is the total asset turnover ratio.
The working capital to assets ratio measures dollars of working capital per dollar of assets. Working capital equals current assets minus current liabilities. This ratio measures how good the cushion available for short-term financial obligations is with reference to total assets.
The retained earnings to total assets ratio measures the reserves retained by a company in comparison to total assets. Higher retention increases equity and reduces proportion of debt in the capital structure.
The EBIT to total assets roughly equals the operating return on total assets, i.e. the dollars earned per total of assets before interest and taxes.
The market capitalization to liabilities ratio measures the market value of equity with book value of liabilities. Higher market value of equity with reference to liabilities indicates financial strength.
The total asset turnover ratio equals sales divided by total assets. It measures how efficiently a company has been using its assets to generate revenue.
A z-score of less than 1.81 indicates financial distress, a score above 3 shows that the company is safe and in-between we have a grey area.
Written by Obaidullah Jan, ACA, CFA and last modified on