Altman Z-Score Example: Scoring a Company From Its 10-K

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5. That’s the whole model, published by Edward Altman in 1968 in the Journal of Finance and built on a sample of publicly traded manufacturers. Each X is a ratio from the annual report, the weights were fitted to separate firms that went bankrupt from firms that didn’t, and the total lands in one of three zones: below 1.81 is distress, 1.81 to 2.99 is grey, and above 2.99 is safe. Every input traces to a line in the 10-K.

The inputs and where they live

Ratio	Calculation	Where in the 10-K
X1	Working capital ÷ total assets	Balance sheet: current assets minus current liabilities
X2	Retained earnings ÷ total assets	Balance sheet, shareholders’ equity section
X3	EBIT ÷ total assets	Income statement: operating income
X4	Market value of equity ÷ total liabilities	Share count from the cover page, price from a quote page
X5	Sales ÷ total assets	Income statement: revenue

Total liabilities isn’t always printed as a single line. If it’s missing, subtract total shareholders’ equity from total assets. Retained earnings shows up as “accumulated deficit” when it’s negative, and a negative X2 is allowed; it simply pulls the score down.

For X4, multiply the shares outstanding on the 10-K cover page by a recent share price, adding every share class together, and if the filing reports several different counts, the share count in a 10-Q explains which one belongs in a market value.

Company F, worked through

Company F is a hypothetical manufacturer. Its figures, in millions:

Company F sits in the grey zone, close to safe but short of it.

Look at which terms did the work. X5 and X4 contributed 1.82 of the 2.72 between them. Profitability, the X3 term, contributed 0.30 even though it carries the largest weight, because operating income is small relative to total assets for most industrial firms.

What the market can do to the score

X4 is the only input that moves every trading day. Suppose Company F’s share price falls 40%, with nothing else changed.

Still grey, but a third of the way toward distress, without a single change to the business. That’s intended: a falling share price is the market’s own estimate that the company is worth less, and X4 exists to capture it. It does mean a score computed in a falling market drifts lower each week until the next filing comes out.

What working capital does to it

X1 is often the first term to move when a company gets into trouble. Suppliers tighten terms, a credit line gets drawn and classified as current, or a bond moves inside twelve months of maturity and lands in current liabilities in a single quarter.

Only the calendar changed. If the company refinances, the bond moves back to long-term debt and the score recovers; if it can’t, the next filing shows the problem in cash. Both outcomes start from the same score. Keep the debt maturity table from the notes beside it.

Computed scores on screeners

Some screeners and quote pages show a Z-score. Before relying on one, find out what went into it. The share price behind X4 may be today’s, set against balance sheet figures several months old. EBIT and sales may be trailing twelve months, which can differ a lot from the last 10-K. And a tool may apply the original manufacturer weights to every company, retailers and software firms included, where Z double prime is the right fit. The field definitions should say.

Non-manufacturers: Z double prime

Retailers, service firms and software companies turn their assets over at very different rates from a factory, which makes X5 misleading for them. Altman’s revised model for non-manufacturers drops X5, uses book equity in X4, and reweights:

Z'' = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4

The zones change too: below 1.1 is distress and above 2.6 is safe.

Just over the safe line. Match the version to the business. Never compare a Z with a Z double prime.

Where the score misleads

Buybacks can wreck X2. Companies that retire repurchased shares often charge part of the cost against retained earnings, and a mature, profitable firm with years of buybacks behind it can carry low or even negative retained earnings while generating plenty of cash. Its score will look worse than its condition.

Asset-light companies get the opposite problem. A firm with little on its balance sheet and steady revenue posts a large X5 and a comfortable score that says little about how it would handle a revenue drop.

Leases and off-balance-sheet obligations change total liabilities, which hits X4. The debt-to-equity page covers how lease liabilities and other debt-like items are counted, and the same choices apply here.

Read the trend, then the filing

One score is a snapshot. Work out three to five years from successive 10-Ks and watch the direction, especially X1, since shrinking working capital shows up there before it shows up anywhere else; the current and quick ratios look at the same working capital from the liquidity side. A score that falls into the grey zone and keeps sliding is a reason to read the debt note and the liquidity discussion in MD&A, which reading a 10-K shows how to find, and to check the auditor’s report for going concern language. The metrics index lists the individual balance sheet ratios the Z-score is built from.