Altman Z-Score

Overview

Altman Z-Score is a linear discriminant model predicting bankruptcy probability from five financial ratios. Z = 1.2X₁ + 1.4X₂ + 3.3X₃ + 0.6X₄ + 1.0X₅. Zones: Z > 2.99 (safe), 1.81-2.99 (grey), Z < 1.81 (distress). Originally for public manufacturing firms; variants exist for private and non-manufacturing.

When to Use

Trigger conditions:

• Screening companies for bankruptcy risk
• Quick credit assessment using publicly available financials
• Monitoring portfolio companies for financial distress signals

When NOT to use:

• For financial institutions (banks, insurers) — different capital structures
• When detailed credit scoring is needed (use logistic regression credit models)

Algorithm

IRON LAW: Z-Score Was Calibrated for PUBLIC MANUFACTURING Firms
Applying the original formula to private firms, service companies, or
emerging markets WITHOUT using the appropriate variant produces
misleading results. Use Z'-Score for private firms, Z''-Score for
non-manufacturing and emerging markets.

Phase 1: Input Validation

Extract from financial statements: working capital, retained earnings, EBIT, market cap (or book equity for private), total assets, total liabilities, sales. Gate: All five inputs available, from same reporting period.

Phase 1.5: Variant Selection (MANDATORY)

Before touching any formula, pick the right variant — this is the single most common mistake when applying Altman Z.

Firm description	Variant	Script flag
Public manufacturing firm	Original Z	--variant original
Private manufacturing firm (no market cap)	Z'	--variant private
Non-manufacturing — SaaS, services, retail, tech, finance-light	Z''	--variant non_manufacturing
Emerging-market firm of any kind	Z''	--variant non_manufacturing

If the user description contains any of these tags: "SaaS", "cloud", "software", "services", "retail", "e-commerce", "platform", "tech", "emerging market", "BRICS", "non-manufacturing" → use Z''. Do not default to the original Z just because that's the "classic" formula.

Full formulas and zone thresholds for each variant live in references/z-score-variants.md. Coefficients, X₄ definition (market cap vs book equity), and the X₅ treatment all differ between variants — they are not small tweaks to the original.

Phase 2: Core Algorithm

1. X₁ = Working Capital / Total Assets (liquidity)
2. X₂ = Retained Earnings / Total Assets (cumulative profitability)
3. X₃ = EBIT / Total Assets (operating efficiency)
4. X₄ = Market Value of Equity / Total Liabilities (leverage)
5. X₅ = Sales / Total Assets (asset turnover)
6. Z = 1.2X₁ + 1.4X₂ + 3.3X₃ + 0.6X₄ + 1.0X₅

Phase 3: Verification

Check: all ratios in plausible ranges. Compare Z-score against industry peers and historical trend. Gate: Z-score computed, zone classification assigned.

Phase 4: Output

Return Z-score with component breakdown and zone classification.

Output Format

{
  "z_score": 2.45,
  "zone": "grey",
  "components": {"X1": 0.12, "X2": 0.25, "X3": 0.08, "X4": 1.5, "X5": 0.9},
  "metadata": {"model": "original", "company": "...", "period": "2024-Q4"}
}

Examples

Sample I/O

Input: WC=200M, RE=500M, EBIT=150M, MktCap=2B, TL=1B, TA=3B, Sales=2.5B Expected: X1=0.067, X2=0.167, X3=0.05, X4=2.0, X5=0.833. Z=1.2(0.067)+1.4(0.167)+3.3(0.05)+0.6(2.0)+1.0(0.833)=2.53 → Grey zone.

Edge Cases

Input	Expected	Why
Negative retained earnings	Low X₂, likely distress	Accumulated losses are a strong distress signal
Startup with no revenue	X₅ near zero	Z-score not designed for pre-revenue companies
Asset-light tech firm	Misleading X₅	High revenue/low assets inflates turnover

Gotchas

• Model age: Calibrated in 1968 on 1946-1965 data. Business models, accounting standards, and capital structures have changed. Use as one signal, not sole determinant.
• Accounting manipulation: Z-score uses reported financials. Creative accounting (off-balance-sheet debt, revenue recognition games) can mask distress.
• Industry differences: Capital-intensive industries naturally have lower asset turnover (X₅). Compare within industry, not across.
• Trend matters more than level: A company moving from Z=3.5 to Z=2.1 over two years is concerning even though 2.1 is still in the grey zone.
• Private firm variant (Z'): replaces X₄ with Book Equity / Total Liabilities and re-weights: Z' = 0.717X₁ + 0.847X₂ + 3.107X₃ + 0.420X₄ + 0.998X₅. Zone thresholds shift to 2.9 / 1.23.
• Non-manufacturing variant (Z''): drops X₅ entirely and re-estimates the rest: Z'' = 6.56X₁ + 3.26X₂ + 6.72X₃ + 1.05X₄. Zone thresholds shift to 2.6 / 1.1. Using original Z on a SaaS / services firm inflates the score via X₅ and can mis-zone a distressed firm as safe.

Scripts

Script	Description	Usage
scripts/altman_z.py	Compute Altman Z-Score and classify zone	python scripts/altman_z.py --help

Run python scripts/altman_z.py --verify to execute built-in sanity tests.

References

• references/z-score-variants.md — Z / Z' / Z'' full formulas, zone thresholds, variant-selection rules, and a worked tech-firm example.