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Z-Score
See bottom of page for other sources of information on Z-Score
BANKRUPTCY PREDICTION
Any single one of the 20 or so acknowledged financial ratios cannot adequately evaluate
the overall strength of a company, although each of them can be extremely useful in
identifying specific strengths and weaknesses that contribute to the general financial
health of the firm.
The Z-Score Bankruptcy-Predictor combines several of the most significant variables in a
statistically derived combination that was first published by Dr. Edward I. Altman in 1968
(See The Journal of Finance, September, 1968.) It was originally developed on a sampling
of manufacturing firms. However, the algorithm has been consistently reported to have a 95
% accuracy of prediction of bankruptcy up to two years prior to failure on non
manufacturing firms as well. There have been many other bankruptcy predictors developed
and published. However, .none has been so thoroughly tested and broadly accepted as the
Altman Z-Score. The Altman Z-Score variables influencing the financial strength of a firm
are:
CA = CURRENT ASSETS
TA = TOTAL ASSETS
SL = NET SALES
IN = INTEREST
TL = TOTAL LIABILITY
CL = CURRENT LIABILITIES
VE = MARKET VALUE OF EQUITY
ET = EARNINGS BEFORE TAXES
RE= RETAINED EARNINGS
X1 = CA-CL divided by TA
The least significant of factors, this is a measure of the net liquid assets of the firm
in relation to total assets. CA - CL is known as Working Capital.
X2 = RE divided by TA
A more significant factor. A measure of profitability over time. The Retained Earnings
Account is subject to manipulation and a bias could be created.
X4 = VE divided by TL
More significant than the former. An indication of the firm's ability to suffer a decline
in value of assets. In closely held firms, VE may be substituted with (TA - TL). Users are
cautioned that this is a proxy that has not been statistically verified.
X5 = SL divided by TA
Next to the most significant factor. It illustrates the sales generating ability of the
firm's assets.
X3 = ET + IN divided by TA
The most important factor. Profit is the principal objective and is the force that
eventually determines the vitality of the firm. Interest is added to the earnings as this
cost does not detract from the earning power of the firm. Combining the above to provide a
numerical value that can indicate the strength of the firm we have:
Z = 1.2xX1 + 1.4xX2 + 0.6xX4 + 1.OxX5* + 3.3xX3
The Z-Score calculated for Generic Retail is 8.50.
When Z is: the firm is:
3.0 or more, most likely safe based on the financial data. Of course, mismanagement,
fraud, economic downturns, and other factors may cause an unexpected reversal.
2.7 to 3.0,
Probably safe to predict survival, but this is a portion of the gray area and is below the
threshold of relative safety.
1.8 to 2.7
Likely to be bankrupt within two years. This is the lower portion of the gray area and
dramatic action may be required to effect survival.
Below 1.8
Highly likely headed for bankruptcy. Rarely would a firm be expected to recover from a
financial condition generating this or lower scores.
Since Total Assets is the denominator of the X5 factor, small values here in relation to
Sales can provide a ratio of large numerical value. The user is cautioned that values in
excess of 3 t o 1 may distort the predictor to provide an unwarranted favorable score.
This may also be an indication that the firm is under-capitalized in order to support the
sales volume attained. The analyst may wish to limit this ratio to 3 to 1, if inordinately
high Z Scores are obtained on firms that otherwise indicate softness. Since the Z Score
model is based on manufacturing firms, the result may be more useful as a trend indicator
for other types of firms. But scores of less than 3.0 should be considered cause for
serious inquiry.
Other applications of the Z Score include use as one of the factors in the evaluation of
the credit worthiness of a firm and a factor in selecting firms for stock and bond
investment.
Other Sources of Information on Z-Score:
http://www.luca.com/cpajournal/old/16641866.htm
http://www.ventureline.com/glossary.htm#Altman’s
"Z-SCORE"
http://www.inc.com
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