Z-Score Financial Analysis Tool

Z-Score Financial Analysis Tool

The Z-score formula for predicting bankruptcy was developed in 1968 by Edward I. Altman, a financial economist and professor at the Leonard N. Stern School of Business at New York University. The Z-score is a multivariate formula that measures the financial health of a company and predicts the probability of bankruptcy within two years.

Studies measuring the effectiveness of the Z-score have shown the model to be accurate with >70% reliability (Eidleman). The Z-score combines four or five common business ratios using a weighting system calculated by Altman to determine the likelihood of bankruptcy. The weighting system was originally based on data from publicly held manufacturers, but has since been modified for private manufacturing, non-manufacturing and service companies.

The original data sample consisted of 66 firms, half of which had filed for bankruptcy under Chapter 7. All businesses in the database were manufacturers, and small firms with assets of <$1million were eliminated.

The original score was as follows: Z = 1.2T1 + 1.4T2 + 3.3T3 + .6T4 + .999T5.

T1 = Working Capital / Total Assets. Measures liquid assets in relation to the size of the company.

T2 = Retained Earnings / Total Assets. Measures profitability that reflects the company's age and earning power.

T3 = Earnings Before Interest and Taxes / Total Assets. Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.

T4 = Market Value of Equity / Book Value of Total Liabilities. Adds market dimension that can show up security price fluctuation as a possible red flag.

T5 = Sales/ Total Assets. Standard measure for turnover (varies greatly from industry to industry).

Altman found that the ratio profile for the bankrupt group fell at -0.25 avg, and for the non-bankrupt group at +4.48 avg.

From about 1985 onwards, the Z-scores have gained acceptance by auditors, management accountants, courts, and database systems used for loan evaluation (Eidleman). It has been used in a variety of contexts and countries, but was designed originally for publicly held manufacturing companies with assets of more than $1 million. Later revisions take into account the book value of privately held shares, and the fact that turnover ratios vary widely in non-manufacturing industries.

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Original Z-score Component Definitions Variable Definition Weighting Factor

T1 = Working Capital / Total Assets

T2 = Retained Earnings / Total Assets

T3 = Earnings Before Interest and Taxes / Total Assets

T4 = Market Value of Equity / Book Value of Total Liabilities

T5 = Sales/ Total Assets

Z Score Bankruptcy Model:

Z = 1.2T1 + 1.4T2 + 3.3T3 + .6T4 + .999T5

Zones of Discrimination:

Z > 2.99 -“Safe” Zone 1.8 < Z < 2.99 -“Grey” Zone

Z < 1.80 -“Distress” Zone

Z'-score Component Definitions Variable Definition Weighting Factor for Private Firms

T1 = (Current Assets-Current Liabilities) / Total Assets

T2 = Retained Earnings / Total Assets

T3 = Earnings Before Interest and Taxes / Total Assets

T4 = Book Value of Equity / Total Liabilities

T5 = Sales/ Total Assets

Z' Score Bankruptcy Model:

Z' = .717T1 + .847T2 + 3.107T3 + .420T4 + .998T5

Zones of Discrimination:

Z' > 2.9 -“Safe” Zone

1.23 < Z' < 2. 9 -“Grey” Zone

Z' < 1.23 -“Distress” Zone

Z-score Component Definitions Variable Definition Weighting Factor for Manufacturers, Non-Manufacturer Industrials & Emerging Market Credits

T1 = (Current Assets-Current Liabilities) / Total Assets T2 = Retained Earnings / Total Assets

T3 = Earnings Before Interest and Taxes / Total Assets

T4 = Book Value of Equity / Total Liabilities

Z-Score Bankruptcy Model:

Z = 6.56T1 + 3.26T2 + 6.72T3 + 1.05T4

Zones of Discrimination:

Z > 2.6 -“Safe” Zone

1.1 < Z < 2. 6 -“Grey” Zone

Z < 1.1 -“Distress” Zone

References

*cite journal
last = Altman
first = Edward I.
authorlink = Edward I. Altman
title = "Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy"
journal = Journal of Finance
pages = 189-209
date = September, 1968

*cite journal
last = Altman
first = Edward I.
authorlink = Edward I. Altman
title = "Revisiting Credit Scoring Models in a Basel II Environment"
journal = prepared for "Credit Rating: Methodologies, Rationale, and Default Risk", London Risk Books 2002
date = May, 2002
url = http://www.stern.nyu.edu/fin/workpapers/papers2002/pdf/wpa02041.pdf

* cite journal
last = Eidleman
first = Gregory J.
title = Z-Scores - A Guide to Failure Prediction
journal = The CPA Journal Online
date = 1995-02-01
url = http://www.nysscpa.org/cpajournal/old/16641866.htm

* [http://pages.stern.nyu.edu/~ealtman/3-%20CopCrScoringModels.pdf The Use of Credit Scoring Modules and the Importance of a Credit Culture] by Dr. Edward I Altman, Stern School of Business, New York University.

ee also

* Standard score
* Z-test
* Z-factor

Further reading

Caouette, John B; Edward I Altman, Paul Narayanan (1998). "Managing Credit Risk - the Next Great Financial Challenge", John Wiley & Sons: New York. ISBN 978-0471111894


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