What It Measures
The z-score is a measure of the financial health of a company. Devised in the 1960s by Edward Altman, the score uses statistical techniques to predict the likelihood that a company will fail because of bankruptcy within two years.
The z-score was originally created based on Altman’s analysis of 33 bankrupt manufacturing companies with assets averaging $6.4 million and a further 33 nonbankrupt companies with assets between $1 million and $25 million. Altman’s analysis showed that 95% of the bankrupt companies had a z-score that suggested financial problems.
Why It Is Important
Since the 1980s, auditors have used the z-score to help identify companies with serious cash problems. The measure is also used to help score applicants for loans. Stockbrokers commonly use the z-score to determine if a company is a good investment.
How It Works in Practice
The z-score combines five common business ratios and uses a weighting system devised by Altman to produce a score somewhere between −4 and +8. Each of the components that make up the final z-score are rated independently, and each component has a different weight in the calculation of the overall z-score. The exact emphasis on each factor can vary slightly from one industry to another, using more specific z-score calculators.
All the information needed to calculate a z-score is available in company financial reports. The original formula to calculate a z-score is as follows:
z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.999T5
T2 = retained earnings ÷ total assets
T3 = earnings before interest and tax ÷ total assets
T5 = sales ÷ total assets
A score can be analyzed as follows:
> 2.99: the company is considered “safe”
1.8–2.99: there is some risk of financial distress
< 1.8: there is serious risk of financial distress
Tricks of the Trade
Although the numbers that go into the z-score can be influenced by external events, it is a useful tool to provide a quick analysis of where a company stands compared to competitors, and for tracking the risk of insolvency over time.
Studies have shown the z-score is an accurate prediction of company failure rates in between seven and eight out of 10 cases.
The formula was originally devised to be used for public companies, but amendments have since been made to allow z-scores to be calculated for privately held companies. In this case, the calculation that should be used is as follows:
0.717T1 + 0.87T2 + 0.420T4 + 0.998T5