Altman Z'-Score: formula and interpretation
The Altman Z-Score is a statistical model (Altman, 1968) that combines five financial ratios into a single figure to gauge how likely a company is to fall into distress. Z' is the 1983 revision for private companies, using book equity instead of market capitalisation. It is a screening signal for deciding where to look closer, not a verdict on whether a company will fail.
Formula
Z' = 0.717·X1 + 0.847·X2 + 3.107·X3 + 0.42·X4 + 0.998·X5
- X1 = net working capital (current assets − current liabilities) ÷ total assets: short-term liquidity
- X2 = retained earnings ÷ total assets: accumulated profitability
- X3 = operating profit ÷ total assets: operating return on assets (the original uses EBIT; Caveat uses operating profit)
- X4 = book equity ÷ total liabilities: financial cushion
- X5 = revenue ÷ total assets: asset turnover
Zones (original paper): Z' > 2.9 safe zone, 1.23 to 2.9 grey zone, Z' < 1.23 distress zone.
Worked example
Take a company with total assets of KRW 18 hundred million, current assets of 8, current liabilities of 5, retained earnings of 5, operating profit of 3.2, equity of 9 and revenue of 30 (all in hundred-million KRW). The figures come from Caveat's calculation engine.
| Term | Ratio | Weight | Contribution |
|---|---|---|---|
| X1 net working capital ÷ total assets | 0.167 | 0.717 | 0.119 |
| X2 retained earnings ÷ total assets | 0.278 | 0.847 | 0.235 |
| X3 operating profit ÷ total assets | 0.178 | 3.107 | 0.552 |
| X4 equity ÷ total liabilities | 1.000 | 0.42 | 0.420 |
| X5 revenue ÷ total assets | 1.667 | 0.998 | 1.663 |
| Z' | 2.99 |
A Z' of 2.99 falls in the safe zone. The prior-year value was 2.79.
How to read it
- Position and direction, not just the zone: near a zone boundary, the direction versus the prior year says more than the zone name.
- Which term moved: the terms with the largest contribution (usually X3 operating margin on assets and X5 turnover) drive the score.
- Industry: asset-light, fast-turning service and trading businesses tend to score high through X5, while recently formed companies score low because X2 (retained earnings) has not built up.
Both sides: a low score does not mean failure. It can also appear when investment brought forward inflates total assets or when a new company has not accumulated retained earnings. A high score does not guarantee safety either: the model sees only the financial statement figures and misses customer concentration, litigation or key-person dependence.
Limitations
- The original model was calibrated on US manufacturing samples from the 1960s and 1970s. It may not fit service businesses or Korean SMEs directly, so treat it as a reference signal.
- Caveat uses operating profit in place of EBIT, so non-operating gains and losses are not included.
- Standard financial statements for individual proprietors have no retained earnings, so Z' cannot be calculated for them.
- This is reference analysis and does not replace credit, investment or tax decisions.
FAQ
- Does a low Z'-Score mean the company will fail?
- No. It is a statistical signal built to separate failed and healthy firms in past samples. A low score is a reason to look at the financial position more closely, not a prediction.
- What is the difference between the Z-Score and the Z'-Score?
- The Z-Score is for listed manufacturers and uses market capitalisation in X4. Z' is the revision for private companies: it uses book equity instead and re-estimates the weights and zones.
- Can it be used for service companies?
- The original sample is manufacturing. A variant without the revenue term (Z'') has been proposed for non-manufacturers; Caveat calculates only Z', so read results for service businesses with extra care.
- Which financial statement items are needed?
- Seven: current assets, current liabilities, retained earnings, operating profit, equity, total assets and revenue.