PLUS MoneyWeek Get 4 FREE issues Altman’s original five-ratio model (see Altman Z-score) was designed for manufacturers, or sectors with high capital intensity, such as mining.
The problem is it uses the sales/total assets ratio, which can skew the result in sectors that are not capital intensive. A low total assets figure brings this ratio, and the resulting Z score, down too far and can generate a number that suggests financial distress when there may be none. Low capital intensity sectors include many service sector firms where people, rather than physical assets, are the main source of added value.
A modification to the Z score removes this ratio altogether to leave the remaining four, then re-weights them, still giving the most importance to the first: EBIT to total assets, followed by working capital to total assets, retained earnings to total assets and market capitalisation to total liabilities. It is interpreted similarly to the original Z score. A result of 2.6 or higher is ‘safe’; a score of one or less suggests big trouble.
