How to calculate the Z score ?

The Z-score is a business scoring tool that calculates the probability of default and bankruptcy. This instrument was created by Edward Altman in the 1960s.

It uses a combination of financial ratios from the balance sheet and profit and loss account along statistics about bankrupt companies.

Numerous tests determine its dependability in forecasting bankruptcy one to two years prior to its occurrence. The 1999-completed tests yielded a reasonable probability in 94% of instances.

As of today, many credit analysis departments in the stock market sector use the Z-score as it was created for them. But it is also used in the management of customer credit granted between companies. We can find the Z-score in the reports of several financial information providers.

The indicators taken into account in the calculation

To calculate the Z-score, it is necessary to possess the outcomes of five distinct ratios. An assortment of multipliers are interconnected with each individual in a distinct manner. This is contingent upon a multitude of criteria that differ across business categories, encompassing public, private, and non-manufacturing companies.

A. Working Capital / Total Assets

This indicator highlights the portion of the total balance sheet which finances, in equity, the company's activity. The higher the working capital, compared to the total balance sheet, the greater the financial independence of the company to carry out its activities.

B. Retained Earnings / Total Assets

This metric is used to represent the percentage of a company's total profits reinvested in the organization. We commonly refer to it as the ownership ratio.

An elevation in this ratio signifies that the organization is upholding a sound financial standing. A decrease of the ratio would be indicative of the opposite. As a result, the company has acquired the necessary resources to commence its own financing operations. This covers banks, suppliers, and equivalent entities, among others.

C. Earnings Before Interest and Taxes / Total Assets

This ratio indicates the productivity of assets in generating income. It can be obtained through a crossover operation between the income statement (EBIT, or operating profit) and balance sheet (total assets).

The higher this ratio is, the more the company is attractive to investors, and financially safe. This will make it easier to find investors, if necessary. Banks will also be more willing to accept a loan application.

D. Equity / Total Liabilities

This metric demonstrates the company's financial autonomy, which surpasses that of its equity. Which is comparatively high relative to debts. This means that the company relies on its own resources and profits to sustain its operations. The need to borrow money from banks or rely on suppliers for financing is then non-existent.

This financial independence is a desirable trait for investors. It indicates that the company is financially stable and capable of generating income.

E. Sales/ Total Assets

With the aid of this ratio, it is possible to ascertain the asset productivity required to generate sales. The execution of a calculation will determine the location of this ratio. The successful completion of this task serves as evidence that the company's management team possesses the necessary financial resources to execute business-generation initiatives. The successful completion of the given task confirms it.

Computation mode

In private companies, the calculation of the score is the following:

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

In non-manufacturer companies, we calculate it as follows:
Z-score = 6,56A + 3.26B + 6,72C + 1,05D

Calculate the Z score with our online calculator now.

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) and shows a low probability of failure. A score below 1.23, or 1.1 for non-manufacturing, conversely, signifies an exceptionally high likelihood of failure.

Scores between the two represent a gray area for medium-sized companies where the risk is present but not that strong. Presenting a positive z-score is then essential to display the security of your company. Negative z-scores will act as the opposite for business owners.

The Z-score limits

As with any scoring instrument, the Z score has numerous limitations. Primarily, it concentrates on exclusively financial factors, which is exceedingly simplistic when evaluating a business. To be clear, these criteria constitute merely half of the components that require analysis. To completely analyze risks, we also need to consider other criteria, such as :

• Position in the market,
• the outlook for the sector,
• macro-economic and credit conditions,
• culture and corporate values concerning compliance with commitments,
• etc.

Furthermore, financial items form one of the bases of the score and are difficult to control. If those details are incorrect, the result will be wrong. The timing is also an issue. Financial indicators that are available concern the past only, and sometimes the company's situation of one year and more. They may be obsolete and not representative of the actual situation of the company. In an economic world where everything is going faster and faster, this is certainly one of the biggest limits of financial scoring.  

Ultimately, this category of instrument may experience a numbing effect on the analyst. Especially when he is solely presented with the score. The more interesting and often-missed part lies in the construction stages of the Z-score. We can't possibly reduce a company to a score; doing so would be absurd.

The credit analyst must possess the skill to comprehend the intricate nature of a corporation. This comprehension will enable him to form an individual belief regarding its merits and demerits. It encompassed both financial and non-financial aspects.

The Z-score is an interesting tool and helps to assess the creditworthiness of businesses. It can be used and included in the credit management policy. However, it is important to keep in mind that this tool is only one factor among others allowing to perform a relevant credit analysis. To achieve a complete assessment, it is key to be aware of advantages and disadvantages of each tool and to build the analysis with the intention to understand the reality of a business now. For that, a financial score based on past financial statments remains insufficient.