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Plate 8 of 19 · Finance

Spotting financial distress

About 6 minutes to read, then three questions that count toward your mastery.

Five ratios from the accounts, weighted into one score, separated manufacturers that went bankrupt from those that didn’t. Altman’s Z-score is still the standard first screen.

The idea

In 1968 Edward Altman took 66 US manufacturers, half of which had gone bankrupt, and asked which combination of financial ratios best told the two groups apart. The answer, found by discriminant analysis, was five ratios with fixed weights, added into a single Z-score.

The ratios cover liquidity (working capital), accumulated profit (retained earnings), earning power (EBIT, the largest weight at 3.3), leverage (market value of equity against liabilities) and asset turnover (sales). In the original model a score below 1.81 is the distress zone, above 2.99 the safe zone, and in between a grey zone where the model can’t call it.

Altman later fitted versions for other firms. Z′ for private companies uses book equity. Z″ for non-manufacturers drops sales ÷ assets, because asset turnover differs so much between industries that it would make asset-light firms look strong; it has its own cut-offs, 1.1 and 2.6. It is a screen, not a forecast, and not meant for banks or insurers.

The formula

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

X1
working capital ÷ total assets
X2
retained earnings ÷ total assets
X3
EBIT (operating profit) ÷ total assets
X4
market value of equity ÷ total liabilities
X5
sales ÷ total assets

Zones for this original model: below 1.81 distress, 1.81 to 2.99 grey, above 2.99 safe.

A worked example

Plate 8

A listed manufacturer has total assets of $1,000m, working capital of $150m, retained earnings of $300m, EBIT of $120m, sales of $1,100m, total liabilities of $500m, and shares worth $700m. Where does it fall?

  1. The ratios: X1 = 0.15, X2 = 0.30, X3 = 0.12, X4 = 700 ÷ 500 = 1.40, X5 = 1.10.
  2. Weighted: 1.2 × 0.15 = 0.18; 1.4 × 0.30 = 0.42; 3.3 × 0.12 = 0.40; 0.6 × 1.40 = 0.84; 1.0 × 1.10 = 1.10.
  3. Z = 0.18 + 0.42 + 0.40 + 0.84 + 1.10 = 2.94.
  4. That is between 1.81 and 2.99: the grey zone, just short of safe.

Not a distress signal, but not a clean bill of health either. Turnover and the market’s valuation of the equity carry most of the score; operating profit of 12% of assets is modest for the 3.3 weight it gets. Look closer at profitability and liquidity.

Try it

The original Z for a listed manufacturer. Enter each ratio as a decimal (0.15 for 15%).

0.15
0.30
0.12
1.40
1.10

Score a manufacturer

Z = 2.94grey zone
Largest contribution
Sales ÷ total assets (+1.10)
EBIT ÷ assets needed for the safe zone, others unchanged
0.14
Share of the score from sales ÷ assets
37%

The grey zone: the model can’t separate this company from either group. Look closer at the ratios that pull the score down.

The common mistake

Mixing the two printed forms of the model

Altman’s 1968 paper wrote the first four ratios as percentages (15 for 15%), so its weights read 0.012, 0.014, 0.033 and 0.006, with 0.999 on sales ÷ assets. Using those weights with ratios written as decimals gives 1.12 for this company: a false distress signal. Use 1.2, 1.4, 3.3, 0.6 and 1.0 with decimals.

Remember

  • Original Z: below 1.81 distress, 1.81–2.99 grey, above 2.99 safe.
  • EBIT ÷ total assets carries the largest weight, 3.3: earning power matters most for survival.
  • Use Z′ for private firms and Z″ for non-manufacturers, each with its own cut-offs; none of them suit banks or insurers.

Check yourself

Three questions from the Learn room’s bank. Your answers update your mastery of this skill, the same as in Practise.

Use it on real numbers

Open Altman Z-score, in Finance › Risk management and try the idea on your own numbers.