Accounting Ratios

Altman Z-Score

The Altman Z-score is a combination of five financial ratios weighted by coefficients that is used to estimate the likelihood of financial distress. It was developed in 1968 by Edward I. Altman, an Assistant Professor of Finance at New York University, as a quantitative balance-sheet method of determining a company’s financial health. The coefficients were estimated by identifying a set of firms which had declared bankruptcy and then collecting a matched sample of firms which had survived, with matching by industry and approximate size (assets).

The original Altman Z-Sore was developed for US manufacturing companies and the formula is was as follows:

X1 = Working Capital (Current Assets less Liabilities) / Total Assets. Measures liquid assets in relation to the size of the company.

X2 = Retained Earnings / Total Assets. Measures profitability that reflects the company's age and earning power.

X3 = Earnings Before Interest and Taxes / Total Assets. Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.

X4 = Market Value of Equity / Book Value of Total Liabilities. Adds market dimension that can show up security price fluctuation as a possible red flag.

X5 = Sales / Total Assets. Standard measure for total asset turnover (varies greatly from industry to industry).

The five variables are then weighted together according to the following formula:

Altman Z-Score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5.

A Z-Score above 2.99 suggests that a company is in the Safe Zone based on the financial figures only. A Z-Score between 1.8 and 2.99 is in the Grey Zone which suggests there is a good chance of the company going bankrupt within the next two years of operations. Meanwhile, a Z-Score below 1.80 is in the Distress Zone which indicates a high probability of distress within this time period. We have displayed the scoring system in the following chart to make it easier to understand:

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We have downloaded the Z-Score in FY15 for 3,500 non-finance companies across Asia with a market capitalisation exceeding US$1bn. A surprisingly large number of companies, 22% of total, return a score of less than 1.8, putting them in the danger zone. Around 59% of these are located in Hong Kong and China. Indeed, Hong Kong has the highest incidence rate companies in the distressed zone at 35% of total, as the following table shows. Meanwhile, on a sector basis, Electric Utilities, Real Estate and Airlines have the highest incidence of companies in distress.


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In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years before the event, with a Type II error (classifying the firm as bankrupt when it does not go bankrupt, or false negatives) of 6% (Altman, 1968). In a series of subsequent tests covering three periods over the next 31 years (up until 1999), the model was found to be approximately 80%–90% accurate in predicting bankruptcy one year before the event, with a Type II error of approximately 15%–20% (Altman, 2000). However, this ratio has come under some criticism in recent years given that is was originally designed for manufacturing companies back in the 1960s and drew upon a relatively small sample size.

While Altman’s Z-Score was initially designed for US manufacturing companies, we have incorporated later iterations designed for non-manufacturing and emerging market companies. In these iterations, the 4th variable, which compares market capitalisation to total liabilities, is replaced with equity to total liabilities, as shown below:

X4 = Book Value of Equity / Total Liabilities. Gauges a company’s leverage.

Z-Score bankruptcy model: Z = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4

Z-Score bankruptcy model (Emerging Markets): Z = 3.25 + 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4

Zones of discriminations:

Z > 2.6 -“Safe” Zone

1.1 < Z < 2.6 -“Grey” Zone

Z < 1.1 -“Distress” Zone