The Z score

The Z-score is a company scoring tool that establishs a probability of default. It was created by Edward Altman in the 1960s.

It is based on a statistical approach combining financial ratios from the balance sheet and income statement with statistics about companies that went bankrupt.

Many tests were conducted to determine its reliability in predicting bankruptcy one or two years before it occurs. 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 in the management of customer credit granted between companies.

The indicators taken into account in the calculation

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, or 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 working capital), the decrease in working capital requirements may be the result of other causes, such as 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 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, and 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, which is comparatively high relative to debts.

E. Sales/ Total Assets

This ratio calculates the asset productivity needed to generate sales. It highlights the ability of the management team of the company to create business with the financial resources available.

Computation mode

Private companies:
Z-score = 0,717A + 0,847B + 3,107C + 0,420D + 0,998E

Non-manufacturer companies:
Z-score = 6,56A + 3.26B + 6,72C + 1,05D

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.

Z score interpretation

The higher the score, the lower the probability of failure. A score above 2.9 is very good (2.6 for non-manufacturing) while a 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.

The Z-score limits

Like any scoring tool, the Z score has many inherent 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 part 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, which will allow him to build a personal conviction about its strengths and weaknesses, whether financial or otherwise.

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 allows for this exercise.
Online tools:
Z score calculator
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