The Z Score
Financial insolvency or bankruptcy can be forecasted using the Z Score. The Z Score combines several ratios with a statistical application called MDA - Multiple Discriminate Analysis. The Z Score is highly accurate in predicting bankruptcies. The Z Score is about 90% accurate in forecasting business failures the first year and about 80% accurate the second year.
The Z Score is calculated by adding five ratios with applicable MDA weights:
Z = 1.2 (A) + 1.4 (B) + 3.3 (C) + .6 (D) + .999 (E)
A: working capital / total assets
B: retained earnings / total assets
C: earnings before interest taxes / total assets
D: market value of equities / book value of debt
E: sales / total assets
The following guideline is used to score an organization:
If the Z Score is 1.8 or less, very high probability of bankruptcy.
If the Z Score is 1.81 to 2.99, not sure about bankruptcy.
If the Z Score is 3.0 or higher, bankruptcy is unlikely.
Example: Total Assets = $ 1,000, Retained Earnings = $ 400, Earnings Before Interest Taxes = $ 50, Sales = $ 1,500, Market Value of Stock = $ 600, Book Value of Debt = $ 700, Working Capital = $ 100.
1.2 x ( $ 100 / $ 1,000) = .120
1.4 x ( $ 400 / $ 1,000) = .560
3.3 x ( $ 50 / $ 1,000) = .165
.6 x ( $ 600 / $ 700 ) = .514
.999 x ( $ 1,500 / $ 1,000) = 1.499Total Z Score = 2.86 Not Sure
Written by: Matt H. Evans, CPA, CMA, CFM | Email: email@example.com | Phone: 1-877-807-8756
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