The Altman Z-Score: an early warning for money trouble
The Z-Score squeezes a company’s balance sheet and profits into one number that hints at how close it might be to running out of money. This lesson explains its five ingredients, shows the two main versions side by side, and scores a small bike company both ways so you can see why the version matters.
The question it answers
Bankruptcy rarely comes out of nowhere. Months or years before, the warning signs are usually sitting in the financial statements: thin cash cushions, years of losses, piles of debt. The trouble is that each sign alone is easy to explain away.
Edward Altman, a finance professor, published the Z-Score in 1968. He took a group of manufacturers that had gone bankrupt and a similar group that hadn’t, then searched for the mix of ratios that best told the two apart. The result is a single number. Higher means safer; lower means the company looks more like the ones that failed.
The five ingredients
Most of the ratios divide something by total assets, everything the company owns. That lets you compare a tiny company with a giant one.
- A: Working capital ÷ total assets. Working capital is current assets (cash and things that turn into cash within a year) minus current liabilities (bills due within a year). It’s the short-term cushion. A company that keeps running low on it is living paycheck to paycheck.
- B: Retained earnings ÷ total assets. Retained earnings are all the profits a company has kept, rather than paid out, over its whole life. An older company with a long record of profits scores high here. A young one, or one with years of losses, scores low.
- C: EBIT ÷ total assets. EBIT means earnings before interest and taxes, close to the operating income line. It measures how much the assets are earning right now. In the original version this ratio carries the most weight.
- D: Market value of equity ÷ total liabilities. Market value of equity is the share price times the number of shares. Compared with what the company owes, it shows how far the company’s value could fall before its debts outweigh it.
- E: Sales ÷ total assets. How many dollars of sales each dollar of assets brings in.
Two versions, two sets of cutoffs
The original Z (1968). Built on manufacturers:
Z = 1.2 × A + 1.4 × B + 3.3 × C + 0.6 × D + 1.0 × E
The later Z″, pronounced Z double prime. Altman later made a version for companies that aren’t manufacturers. It drops E, because sales per dollar of assets varies hugely from one industry to another: a grocery chain rings up far more sales per dollar of assets than a power company, and neither is in trouble because of it. It also swaps the market value of equity in D for book equity, the equity shown on the balance sheet, so the stock price plays no part. The weights change too:
Z″ = 6.56 × X1 + 3.26 × X2 + 6.72 × X3 + 1.05 × X4
Here X1, X2 and X3 are the same as A, B and C, and X4 is book equity ÷ total liabilities.
Because the formulas differ, so do the zones:
| Zone | Original Z | Z″ |
|---|---|---|
| Safe | above 2.99 | above 2.60 |
| Grey (unclear) | 1.81 to 2.99 | 1.10 to 2.60 |
| Distress | below 1.81 | below 1.10 |
The grey zone means the numbers alone can’t sort the company either way. A score in the distress zone doesn’t mean bankruptcy is coming, only that the company’s numbers resemble those of companies that failed.
Pebble Creek Bikes Inc. is the made-up bike maker from the statements lessons. For the market value, assume its shares trade at $15, so all 100,000 shares are worth $1,500,000 together.
| Ratio | Math | Value |
|---|---|---|
| A | ($800,000 − $400,000) ÷ $2,000,000 | 0.20 |
| B | $600,000 ÷ $2,000,000 | 0.30 |
| C | $200,000 operating income ÷ $2,000,000 | 0.10 |
| D (original) | $1,500,000 market value ÷ $1,000,000 liabilities | 1.50 |
| E | $2,000,000 sales ÷ $2,000,000 | 1.00 |
| X4 (Z″) | $1,000,000 book equity ÷ $1,000,000 liabilities | 1.00 |
Original Z: 1.2 × 0.20 + 1.4 × 0.30 + 3.3 × 0.10 + 0.6 × 1.50 + 1.0 × 1.00
= 0.24 + 0.42 + 0.33 + 0.90 + 1.00 = 2.89. That’s in the original’s grey zone (1.81 to 2.99).
Z″: 6.56 × 0.20 + 3.26 × 0.30 + 6.72 × 0.10 + 1.05 × 1.00
= 1.312 + 0.978 + 0.672 + 1.050 = 4.01. That’s comfortably in the Z″ safe zone (above 2.60).
Same company, same year, two different answers: grey on one scale, safe on the other. Neither is wrong; they are different tools with different cutoffs. A 2.89 means one thing on the original scale and something else on the Z″ scale, so a number is only meaningful next to the cutoffs it was built for.
Where the Z-Score misleads
- Banks and other financial companies. For a bank, borrowed money (including customer deposits) is the raw material of the business, so its liabilities are huge by design. The Z-Score reads that as danger. Don’t use it on banks, insurers or lenders.
- Young companies. A startup hasn’t had time to pile up retained earnings and may still be losing money, so B and C drag its score down even when it has plenty of cash from investors.
- It’s a snapshot. The balance sheet shows one day. A big loan due next month, or a lost customer next week, won’t show up until the next filing.
- Price can swing the original. Because D uses the share price, a falling stock lowers the original Z even if nothing in the business changed.
For a fuller picture, pair the Z-Score with the cash flow statement and with any going-concern warning in the auditor’s report.
Where to see it on Filing.fyi
Filing.fyi computes the Z″ version, from the company’s own filing, and grades it with the Z″ cutoffs: 2.60 and above is safe, 1.10 to 2.60 is grey, below 1.10 is distress. The card on each company page prints those cutoffs. If another website or book shows a different number for the same company, check which version it used before comparing. Banks and insurers usually get no card at all, because their balance sheets don’t split short-term from long-term items and the formula needs that split. If a score is low, open the latest 10-K and look at the debt notes and the cash on hand. A Z-Score below zero also caps the page’s health score, as explained in how to read a company page. The ratios themselves come from the balance sheet and income statement.
- Working capital
- Current assets minus current liabilities; the short-term money cushion.
- Retained earnings
- All the profits a company has kept over its life instead of paying them out.
- EBIT
- Earnings before interest and taxes; roughly the operating income line.
- Market value of equity
- Share price times the number of shares.
- Book equity
- Assets minus liabilities, as shown on the balance sheet.
- Grey zone
- The middle range where the score can’t tell safe from distressed.
- The Z-Score blends cushion, past profits, current profits, debt and sales into one warning number.
- The original and the Z″ versions use different formulas and different cutoffs.
- Filing.fyi uses Z″; always read a Z-Score next to the cutoffs built for its version.
- It doesn’t fit banks and treats young companies harshly.
- It’s a snapshot of one date, not a forecast.
This lesson is education, not investment advice. Examples use made-up companies and round numbers unless a real filing is named.