The Altman Z-score: what it says about insolvency risk, and what it does not

In 1968, Edward Altman took 66 companies - half bankrupt, half healthy - and looked for the combination of ratios that separated them best. What came out was a five-term formula that predicted bankruptcy two years ahead in roughly 80% of cases. Five decades later, the result still holds.

The five components

For unlisted companies, the variant in current use is:

Z' = 0.717·X1 + 0.847·X2 + 3.107·X3 + 0.420·X4 + 0.998·X5

How to read the result

In the report we use a visual band with the company's position on it, precisely because a single number creates a false impression of precision. The difference between 1.20 and 1.30 is not the difference between bankruptcy and safety.

Where the model behaves badly

Very young companies. X2 - retained earnings - is zero or negative in the first years, which drags the score down no matter how well the business is doing. A two-year-old company growing healthily can land in the red zone without having any problem at all.

Asset-light services. X5 and X3 both have "total assets" as denominator. A consultancy with three laptops and 2 million in turnover obtains enormous X5 values, and the score becomes unnaturally good.

Real estate and holdings. Large assets and low turnover produce exactly the opposite effect.

Unadjusted accounting. The model reads what the books say. Overstated inventory or unadjusted receivables raise the score precisely in the companies where they ought to lower it.

How we use it anyway, to good effect

Not as a verdict, but as a signal and a trend. A Z that falls three periods in a row says something real even if it stays in the green zone. A Z below the threshold but rising says something different from one below the threshold and falling.

That is why the report shows the components separately, not only the sum: when the score moves, you see at once which of the five terms moved it. A Z falling because of X3 is a profitability problem; one falling because of X4 is a leverage problem. They are fixed differently.