Wikipedia says “The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University. The formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company.”
The original Z-score formula 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 sales turnover (varies greatly from industry to industry).
- Zones of Discrimination:
- Z > 2.99 -“Safe” Zone
- 1.8 < Z < 2.99 -“Grey” Zone
- Z < 1.80 -“Distress” Zone
There is also a revised Z score for non-manufacturing firms
Z-score estimated for 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
Old School Value has a spreadsheet for calculating Z score for any company by typing in a ticker.