The Z-score is a company scoring tool establishing a probability of default. It was created by Edward Altman in the 1960s.
It is based on a statistical approach combining financial ratios coming from the balance sheet and income statement and statistics about companies that went bankrupt.
Many tests were conducted to determine its reliability in predicting bankruptcy one or two years before they occur. The latest tests completed in 1999 gave a fair probability in 94% of cases.
Today the Z score is used by many credit analysis departments in the stock market sector (for which it was created) and the management of customer credit granted between companies.
The Z-score is calculated by adding the results of five ratios that are each associated with a different multiplier. This varies depending on the type of company (public, private and non-manufacturing)
A. Working Capital / Total Assets
This ratio was included because a company in difficulty would reduce its working capital due to the reduction of its activity.
Although true (a revenue decrease often results in a reduction of the working capital), the decrease of the working capital requirements may be the result of other causes such an optimization of internal processes (better inventory management) and external processes (better collection of receivables) that improve the financial health of the company. Not the contrary
B. Retained Earnings / Total Assets
This ratio shows the share of accumulated profits reinvested in the company. The higher this ratio, the more the company is financially healthy as it is able to finance itself its business without help of third parties (banks, suppliers ... etc.).
C. Earnings Before Interest and Taxes / Total Assets
This ratio crossover between the income statement (EBIT or operating profit) and balance sheet (total assets) shows the productivity of assets to generate income. The higher this ratio, the more the company is attractive to investors, so financially safe (it will be easy to find investors if necessary).
D. Equity / Total Liabilities
This indicator shows the financial independence of the company that is even stronger than its equity is comparatively high relative to debts.
E. Sales/ Total Assets
This ratio calculates the asset productivity to generate sales. It highlights the ability of the management team of the company to create business with financial resources available.
Z-score = 0.717A + 0.847B + 3.107C + 0.420D + 0.998E
Z-score = 6.56A + 3.26B + 6.72C + 1.05D
Z-score = 1.2A + 1.4B + 3.3C + 0.6D + 1E
Calculate the Z score with our online calculator.
What is a non-manufacturing company? It is a service company that does not manufacture products. Balance sheet structures are significantly different between this type of business and industrial companies.
The higher the score, more the probability of failure is low. A score above 2.9 is very good (2.6 for non-manufacturing) where score below 1.23 (1.1 for non-manufacturing) indicates a very high probability of failure.
Scores between the two represent a gray area for medium-sized companies where the risk is present but not very strong.
Like any scoring tool, the Z score has intrinsically many limits. First, it focuses on purely financial criteria, which is very reductive in the assessment of a company. These criteria (which are essential, let us be clear) are only half of the elements of a complete analysis.
Positioning in the market, the outlook for the sector, macro-economic conditions, culture and corporate values concerning compliance with commitments ... etc. are all criteria necessary for quality risk analysis.
Furthermore, the score is based on financial items which are difficult to control. Are they correct? If not, the result will be wrong.
Finally, this type of tool can have a numbing side because the analyst sees only the score while the more interesting lies in the construction stages of the Z-score. A company can't be reduced to a score, that's absurd. This is a complex entity and the art of the credit analyst is to understand this reality that will allow him to build a personal conviction about its strengths and weaknesses, whether financial or other.
The Z-score is a tool that can be used in assessing the risk of failure of a business, but it is only one factor among others that allow to perform this exercise.