Z-Score

The Z-score is a linear combination of five common business ratios weighted by coefficients. The Z-score is a private company risk score that was developed by NYU Professor Edward Altman, Ph.D. It measures the relative likelihood of a business facing potential bankruptcy in the next three-year period. Measurement is based on the normative data for the firm within an industry, size, and geographic location.

Z-scores are used to predict corporate defaults. If a company has unstable earnings and high debt, the company is a candidate for bankruptcy. In academic studies, Z-scores are easy-to-calculate control measures for the financial distress status of companies. In a series of tests covering three periods over 31 years, the model was found to be approximately 80%–90% accurate in predicting bankruptcy one year before the event, with a type II error (classifying the firm as bankrupt when it does not go bankrupt) of approximately 15%–20% (Altman, 2000).

Z-Score Estimated for Private Firms

T₁ = (Current Assets − Current Liabilities) / Total Assets

T₂ = Retained Earnings / Total Assets

T₃ = Earnings before Interest and Taxes / Total Assets

T₄ = Book Value of Equity / Total Liabilities

T₅ = Sales / Total Assets

Z-Score Bankruptcy Model

Z = 0.717T₁ + 0.847T₂ + 3.107T₃ + 0.420T₄ + 0.998T₅

Zones of Discrimination

“Safe” Zone:	Z > 2.9
“Gray” Zone:	1.23 < Z < 2.9
“Distress” Zone:	Z < 1.23