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Z-Score Definition

A model that predicts the likelihood that a firm will go bankrupt. The model uses five financial ratios that combine in a specific way to produce a single number. This number, called the Z Score, is a general measure of corporate financial health. Complete Article

Components needed to calculate the Z Score:

The Z Score is calculated by multiplying several financial ratios by an appropriate coefficient and then summing the results. The ratios rely on the following financial measures. (Use balance sheet figures from the end of the reporting period for all Z Score calculations.)

IMPORTANT: exclude commas or decimal values

Working Capital ($)= Current Assets minus Current Liabilities.

Total Assets ($) = The total of all Assets of the Balance Sheet.

Retained Earnings ($) = Found in the Equity section of the Balance Sheet.

EBIT (Earnings Before Interest and Taxes) ($) = Net Income; add back any income tax expenses and subtract any income tax benefits; then add back any interest expenses. (Includes the income or loss from operations and from any unusual or extraordinary items but not the tax effects of these items)

Market Value ($) = The number of shares of common and preferred stock outstanding times the price per share, compared

Net Worth; Shareholders' Equity; or Equity ($) = Total Assets minus Total Liabilities.

Book Value of Total Liabilities ($) = The sum of all current and long-term liabilities from the Balance Sheet.

Sales ($) = Revenues from the Income Statement, including other income.

Z1:

Z2:

Z- Score Results Explanation

The table shows how these measures are used to calculate the three versions of the Z Score. The table is explained below.

Reasons for Multiple Versions

Two of the ratios shown in the figure have tended to limit the usefulness of the original Z Score measure. One of these ratios is X4, the Market Value of Equity divided by Total Liabilities. If a firm is not publicly traded, its equity has no market value. So, private firms can’t use the Z Score. The other problem is X5, Assets Turnover. This ratio varies significantly by industry. Jewelry stores, for example, have a low asset turnover, while grocery stores have a high turnover. However, since the Z Score expects a value standard to manufacturing, it could be biased in such a way that a healthy jewelry store looks sick and a sickly grocery store looks healthy.

To deal with these problems, Altman used his original data to calculate two modified versions of the Z Score, shown above. The Z Score is for public manufacturing companies, the Z1 Score is for private manufacturing companies, and the Z2 is for general use. Therefore, according to the table, if a company’s Z2 score exceeds 2.60, it’s currently safe from bankruptcy. If the score is less than 1.10, it’s headed for bankruptcy. Otherwise, it’s in a gray area.

How to Interpret the Z Score

The Z Score is not intended to predict when a firm will file a formal declaration of bankruptcy. Instead, it measures how closely a firm resembles other firms that have filed for bankruptcy. It is a measure of corporate financial distress and economic bankruptcy.

How accurately does the Z Score measure economic bankruptcy? The original model has drawn several statistical objections over the years. The model uses unadjusted accounting data, data from relatively small firms, and data that today is nearly 60 years old.

And yet, despite these concerns, the original Z Score model is the best-known and most widely used measure of its kind. This measure is imperfect, but it’s easy to calculate in Excel, and many users continue to find it helpful. At last count, for example, Google offered 308,000 links to the phrase “Z Score”.

The Z Score model is a tool that can complement your other analytical tools. Seldom, however, should you use any of the Z Score measures as your only means of analysis.

Author: Analia Miguel

Z Score Calculator

Z-Score Definition

Z- Score Results Explanation

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