Altman Z-Score — Financial Distress Screening (India)
Disclaimer: The Altman Z-Score was designed for manufacturing/industrial companies. Do not apply it reliably to banks, NBFCs, or insurance companies.
Learning Objectives
After reading this chapter, you will be able to:
- Apply: Altman Z-Score (1968, Edward Altman) predicts financial distress from five financial ratios
- Apply: Z > 3 = safe; 2–3 = monitor; 1.8–2 = warning; < 1.8 = distress zone
- Apply: Graham Number (price) + Altman Z (health) = powerful value investing combination
- Explain how excellent for manufacturing/industrial; not for banks/NBFCs/insurance
Introduction
The Altman Z-Score answers: "Can this company survive financially?"
Cheap price + weak balance sheet = value trap. The Graham Number tells you if a share looks cheap; Altman Z tells you if the company is financially healthy enough to survive long enough for value to materialise.
Most useful on manufacturing/industrial names listed on NSE/BSE. Do not apply the standard Z formula to banks/NBFCs where debt is the core product.
Core Concepts
Financial Terms
| Term | Meaning |
|---|---|
| Altman Z-Score | Bankruptcy/distress risk indicator (1968, Edward Altman) |
| Working Capital | Current Assets − Current Liabilities |
| Retained Earnings | Cumulative undistributed profits |
| EBIT | Earnings Before Interest & Tax |
| Financial Distress | Near-term solvency/continuity risk |
| Value Trap | Cheap on valuation, weak on fundamentals |
Investment Decision
Strong candidate when:
- ✅ Graham attractive
- ✅ Altman Z > 3
- ✅ ROCE strong
- ✅ Debt low
Reject when: Graham looks cheap but Altman Z < 1.8, ROCE is weak, and debt is high — "It is not enough to be cheap; the company must be financially healthy."
Five pillars Altman measures:
- Liquidity — Is working capital sufficient for operations?
- Retained earnings history — Profitable track record?
- Current profitability — Is EBIT healthy?
- Solvency — Can market value cover liabilities?
- Efficiency — Sales generated from assets?
Formula & Explanation
Original Altman Z (Manufacturing)
Z = 1.2X₁ + 1.4X₂ + 3.3X₃ + 0.6X₄ + 1.0X₅| Variable | Meaning |
|---|---|
X₁ | Working Capital / Total Assets |
X₂ | Retained Earnings / Total Assets |
X₃ | EBIT / Total Assets |
X₄ | Market Value of Equity / Total Liabilities |
X₅ | Sales / Total Assets |
Worked Example
| Variable | Calculation | Value |
|---|---|---|
X₁ | ₹200 Cr WC / ₹1,000 Cr Assets | 0.20 |
X₂ | ₹300 Cr RE / ₹1,000 Cr | 0.30 |
X₃ | ₹150 Cr EBIT / ₹1,000 Cr | 0.15 |
X₄ | ₹2,000 Cr Mkt Cap / ₹1,000 Cr Liabilities | 2.00 |
X₅ | ₹1,200 Cr Sales / ₹1,000 Cr | 1.20 |
Z = 1.2(0.20) + 1.4(0.30) + 3.3(0.15) + 0.6(2.00) + 1.0(1.20) = 3.55Score Interpretation
| Z-Score | Zone | Meaning |
|---|---|---|
| > 3 | Safe | Strong; low bankruptcy risk |
| 2 – 3 | Grey | Acceptable; monitor |
| 1.8 – 2 | Warning | Deep-dive required |
| < 1.8 | Distress | High financial risk |
Visual Guide
Worked Example — Indian Market
Graham + Altman Combo
| Co. A | Co. B | |
|---|---|---|
| Price | ₹100 | ₹100 |
| Graham Number | ₹180 | ₹180 |
| Altman Z | 4.2 | 1.1 |
Both look cheap on Graham; Co. B is likely a value trap (weak balance sheet).
Real World Example
Friend A: Salary ₹1L/month, Loan ₹10L, Savings ₹20L, saves monthly — low credit risk.
Friend B: Same salary, Loan ₹80L, Savings ₹50K, credit card debt — high credit risk.
Same income, different financial strength. The Altman Z-Score applies the same logic to companies:
- Graham Number asks: "Is the share cheap?"
- Altman Z asks: "Is the company alive and healthy?"
House B (₹40L) is cheaper than House A (₹50L), but cracked walls + legal disputes = bad buy. Cheap stock + weak balance sheet = value trap.
Case Study
| Company A | Company B | |
|---|---|---|
| Debt | Low | High |
| Cash | High | Low |
| Profit | Growing | Falling |
| Sales | Growing | Weak |
| Altman Z | 4.5 | 1.2 |
Same P/E → experienced analyst picks Company A.
Graham + Altman combo:
| Co. A | Co. B | |
|---|---|---|
| Price | ₹100 | ₹100 |
| Graham Number | ₹180 | ₹180 |
| Altman Z | 4.2 | 1.1 |
Co. A is attractive; Co. B is a possible value trap despite cheap Graham.
Value Trap example — Stock X: P/E = 4, Price ₹100, but high debt, low cash, falling profit, Altman Z = 1.3 — dangerous, not cheap.
Best for: Manufacturing, metals, chemicals, industrial, capital goods — Maithan Alloys, Nile, POEL, BEL, HAL
Limited use: Banks, NBFCs, insurance — PFC, REC, ICICI Bank, HDFC Bank, PNB — loans are their product; do not rely on standard Altman Z.
CFA Exam Tip
Practical screening order:
- Altman Z > 3 (manufacturing/industrial)
- ROE > 15%, ROCE > 15%
- Debt low, profit growth healthy
- Graham Number attractive (Price < Graham)
Analogy: Graham = "Is the match expensive?" Altman Z = "Is the person healthy?" Both are needed.
Investor shortcut (5 pillars): Liquidity, Retained profit history, Profitability, Solvency, Efficiency.
Manufacturing rule: Altman Z > 3, ROCE > 15%, Debt/Equity < 0.5 — filters many bad companies early.
Tools: Screener, Tijori, Trendlyne, Bloomberg, Capital IQ — professionals rarely calculate by hand.
Common Mistakes
- Altman Z < 1.8 with attractive Graham/P/E
- Low P/E + falling earnings + weak Z-score
- High debt, low cash, declining profit
- Applying Z-score seriously to banks/NBFCs
- Ignoring Altman when Graham looks attractive
Key Takeaways
- Altman Z-Score (1968, Edward Altman) predicts financial distress from five financial ratios.
- Z > 3 = safe; 2–3 = monitor; 1.8–2 = warning; < 1.8 = distress zone.
- Graham Number (price) + Altman Z (health) = powerful value investing combination.
- Excellent for manufacturing/industrial; not for banks/NBFCs/insurance.
- Value traps often show low P/E + low Altman Z — cheap appearance, dangerous reality.
Practice Questions
Chapter: Altman Z-Score | Part 02 | Try before reading answers.
Q1 (Conceptual): What is the core message of this chapter in one sentence?
Q2 (Calculate): Using chapter numbers: Z = 1.2X₁ + 1.4X₂ + 3.3X₃ + 0.6X₄ + 1.0X₅ — what is Z?
Q3 (Application): How do Altman Z-Score and Working Capital interact in screening decisions?
Q4 (Red Flag): Altman Z < 1.8 with attractive Graham/P/E — why avoid relying on Graham alone?
Q5 (CFA Style): What is a CFA-style trap when interpreting Altman Z-Score?
Q6 (Decision): Altman Z looks strong but valuation is stretched — invest, wait, or avoid?
Q7 (Lab): Complete one Altman Z-Score exercise in Part 02 Practice Lab.
Answer Key
Q1 (Conceptual)
Altman Z-Score predicts financial distress — combine with Graham to avoid value traps.
Q2 (Calculate)
Z = 3.55 (Safe zone) — verify with consolidated annual report figures.
Q3 (Application)
X₁ (Working Capital / Assets) is a direct input — weak liquidity lowers Z even if P/E looks cheap.
Q4 (Red Flag)
Cheap valuation on a distressed balance sheet — company may not survive to realise value.
Q5 (CFA Style)
Applying standard Altman Z to banks/NBFCs where the model was not designed to work.
Q6 (Decision)
Usually wait for margin of safety unless quality is exceptional. Financial health does not justify overpaying.
Q7 (Lab)
See Part 02 Practice Lab and verify with lab Answer Key.
Go deeper: Part 02 Practice Lab
FAQ {#faq}
Q: What should I check after Altman Z screening?
A: Graham Number, ROCE, debt trend, and cash flow — Z alone does not confirm value.
Q: How do I connect theory to Indian market practice?
A: Use Screener/Trendlyne + company annual reports — plot the same metrics over 3 years; paper formulas alone are insufficient.
Q: Altman Z < 1.8 with attractive Graham — why avoid?
A: Value trap — cheap price on a company at risk of financial distress.
Q: High debt, low cash, declining profit — why avoid?
A: Classic distress pattern — Altman Z will likely be in warning/distress zone.
Q: How do I drill these concepts in the Practice Lab?
A: Open Part 02 Practice Lab → use the FAQ Drill row for altman-z-score-intro to practice on real stocks, then verify answers against the Chapter FAQ Quick Index.
Practice Lab FAQ: Full part FAQ index — Part 02 Practice Lab
Related Topics
- Previous Chapter: 11-Graham Number Intro
- Next Chapter: 13-Cash Flow Statement
- Part Overview: Part 02 Financial Statements
- Book Index: Full Table of Contents
Disclaimer: Educational content only. Not investment advice. Consult a qualified financial advisor before investing.