The Z-score model was developed by Edward Altman in 1968 to predict the likelihood of a company’s bankruptcy. Instead of relying on a single performance or liquidity ratio the NYU professor chose five financial ratios and assigned a specific weighting to each individual one. The weightings were derived from an initial data sample based on 66 manufacturing companies.

The sum of all five ratios multiplied by their individual weightings results in a single value, the Z-score, which indicates whether a company may be facing financial difficulties in the near future.

Altman created different models for private and public companies which are distinguished solely by different risk weightings. The Z-score formula for public companies is:

Z = 

• \(\frac{Working \:Capital}{Total\: Assets}\times{1.2}\)
• \( +\:\frac{Retained\: Earnings}{Total\: Assets}\times{1.4}\)
• \( +\: \frac{Market\: Value\: of\: Equity}{Book\: Value \:of\: Debt}\times{0.6}\)
• \( +\:\frac{Sales}{Total\: Assets}\times{0.999}\)
• \( +\:\frac{EBIT}{Total \:Assets}\times{3.3}\)

The lower the Z-score, the more likely it is that a company may face bankruptcy. According to Altman, a score above 3 would be the sign of a financially healthy company, making bankruptcy very unlikely. Any score below 1.8, on the other hand, would represent a very high probability of failure. Any values between 1.8 and 3 are difficult to interpret either way, but lower values may indicate an increased risk of business failure.

The Z-score is a surprisingly reliable indicator of corporate bankruptcy. In independent studies of actual bankruptcies, the Z-score model would have predicted between 72 and 80% of corporate bankruptcies two years in advance. One year prior to the bankruptcy the accuracy of the Z-score model increased up to 90%.

The ratios used by the Z-score model

• The working capital to total assets ratio measures a company’s liquid assets in relation to its size. It gives an indication of a company’s ability to cover short-term financial obligations. Negative working capital (total current assets – total current liabilities) would imply that a company is likely to have difficulties servicing its short-term debt as there are insufficient assets to cover any obligations.
• Retained earnings to total assets (RE/TA) shows a company’s ability to accumulate earnings by using its total assets. Companies with low RE/TA are financing their operations through debt rather than retained earnings. Companies with a high RE/TA, on the other hand, may be more capable of withstanding a bad financial year. A consistently high RE/TA is often closely related to a firm’s age and maturity.
• Earnings before interest and taxes (EBIT) to total assets measures the productivity of a company’s assets. Similar to the return on assets (ROA), it illustrates how well a company uses its assets to generate earnings and recognises that earnings are a key factor for the financial stability of a company’s operations in the long-term.
• The sales to total assets ratio indicates how the company uses its assets to generate sales. It can indicate management’s capacity in dealing with competitive conditions, as, for example, a low market share would be reflected by a low asset turnover.
• The market value of equity to total liabilities gives an assessment of how much the value of a firm exceeds its liabilities. It introduces an element of market confidence in the company into the formula, implying that financial weaknesses would be recognised by the market and be reflected in the share price.

Shortcomings of the model

Despite the relative accuracy of the model, it has several weaknesses. In particular, young companies with little or no earnings will often have a low Z-score without necessarily facing bankruptcy. The Z-score may also be quite volatile, as it can be affected by accounting elements such as write-offs. Finally the sales to assets ratio will vary between industries, and less capital-intensive non-manufacturing companies in particular may have slightly higher Z-scores as a result of the asset turnover ratio.

Nonetheless, the Z-score can be a valuable tool for investors or accountants as it flags when a more thorough analysis of a company’s finances may be required.