The Z Score Ingredients

The Z Score is calculated by multiplying each of several financial ratios by an appropriate coefficient and then summing the results. The ratios rely on these financial measures:

Working Capital is equal to Current Assets minus Current Liabilities. Total Assets is the total of the Assets section of the Balance Sheet. Retained Earnings is found in the Equity section of the Balance Sheet. EBIT (Earnings Before Interest and Taxes) includes the income or loss from operations and from any unusual or extraordinary items but not the tax effects of these items. It can be calculated as follows: Find Net Income; add back any income tax expenses and subtract any income tax benefits; then add back any interest expenses. Market Value of Equity is the total value of all shares of common and preferred stock. The dates these values are chosen need not correspond exactly with the dates of the financial statements to which the market value is compared. Net Worth is also known as Shareholders' Equity or, simply, Equity. It is equal to Total Assets minus Total Liabilities. Book Value of Total Liabilities is the sum of all current and long-term liabilities from the Balance Sheet. Sales includes other income normally categorized as revenues in the firm's Income Statement.

Use balance sheet figures from the end of the reporting period for all Z Score calculations. The following table shows how these measures are used to calculate the three versions of the Z Score. The table is explained below.

In other words, the three Z Score versions (described below) are calculated as follows:

Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + . 6*X4 + X5 Z1 = . 717*X1 + . 847*X2 + 3.107*X3 + .42*X4A + .

998*X5

Z2 = 6.56*X1 + 3.26*X2 + 6.72*X3 + 1.05*X4A

Reasons for Multiple Versions

Two of the ratios shown in the figure have tended to limit the usefulness of the original Z Score measure. One of these ratios is X4, the Market Value of Equity divided by Total Liabilities. Obviously, if a firm is not publicly traded, its equity has no market value. So private firms can't use the Z Score. The other problem is X5, Assets Turnover. This ratio varies significantly by industry. Jewelry stores, for example, have a low asset turnover while grocery stores have a high turnover. But since the Z Score expects a value that is common to manufacturing, it could be biased in such a way that a healthy jewelry store looks sick and a sickly grocery store looks healthy. To deal with these problems, Altman used his original data to calculate two modified versions of the Z Score, shown above. The Z Score is for public manufacturing companies; the Z1 Score is for private manufacturing companies; and the Z2 is for general use.

Therefore, according to the table, if a company's Z2 score is greater than 2.60, it's currently safe from bankruptcy. If the score is less than 1.10, it's headed for bankruptcy. Otherwise, it's in a gray area.

How to Interpret the Z Score

The Z Score is not intended to predict when a firm will file a formal declaration of bankruptcy in a federal district court. It is instead a measure of how closely a firm resembles other firms that have filed for bankruptcy. It is a measure of corporate financial distress, a measure of economic bankruptcy. How accurately does the Z Score measure economic bankruptcy? The original model has drawn several statistical objections over the years. The model uses unadjusted accounting data; it uses data from relatively small firms; and it uses data that today is nearly 60 years old. And yet, despite these concerns, the original Z Score model is the best-known and most widely used measure of its kind. This measure is far from perfect, but it's easy to calculate in Excel and many users continue to find it useful. The Z Score model is a tool that can complement your other analytical tools. Seldom, however, should you use any of the Z Score measures as your only means of analysis.