Z-Score Concept
Z-Score, developed in the 60´s by Edward Altman, is a model of bankruptcy prediction and can be used to detect financial problems in companies listed on the Stock Exchange. The Z-Score calculation formula uses several ratios that derive from the financial demonstrations, namely the following:
X1 = Working Capital / Assets’ Total
X2 = Retained Profits / Assets’ Total
X3 = Profits before financial charges and taxes / Assets’ Total
X4 = Market Capitalization / The Accounting Value of Liabilities
X5 = Sales / Assets’ Total
To calculate Z-Score, the previous ratios are added after they have been multiplied by a certain weighting factor:
Z = 1,2.X1 + 1,4.X2 + 3,3.X3 + 0,6.X4 + X5
According to the model’s authors, a result below 1,81 indicates a strong probability of bankruptcy, while a result above 3 indicates a low probability of bankruptcy.
Naturally that, like other financial analyses models, Z-Score should be prudently analyzed mainly in regards to the quality of the data originating from financial demonstrations – if the accountancy data is far from reality, the conclusion to take from the analyses of the Z-Score result doesn’t have any validity.
