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
where:
T1 = working capital ÷ total assets
T2 = retained earnings ÷ total assets
T3 = earnings before interest and tax ÷ total assets
T4 = market value of equity ÷ book value of total liabilities
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
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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.
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Studies have shown the z-score is an accurate prediction of company failure rates in between seven and eight out of 10 cases.
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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
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