The Z score is a bankruptcy prediction model. The model is frequently used by investors, who can obtain the information needed to derive a Z score from the financial statements of any company. The model has proven to have a high level of accuracy in predicting bankruptcy within one year of the measurement date, with a somewhat reduced level of prediction accuracy within two years of the measurement date. The z score calculation is as follows:
Z = 1.2A x 1.4B x 3.3C x 0.6D x 0.99E
The letters in the formula designate the following measures:
A = Working capital / Total assets [ Measures the relative amount of liquid assets]
B = Retained earnings / Total assets [Determines cumulative profitability]
C = Earnings before interest and taxes / Total assets [measures earnings away from the effects of taxes and leverage]
D = Market value of equity / Book value of total liabilities [incorporates the effects of a decline in market value of a company's shares]
E = Sales / Total assets [measures asset turnover]
A Z score of greater than 2.99 means that the entity being measured is safe from bankruptcy. A score of less than 1.81 means that a business is at considerable risk of going into bankruptcy, while scores in between should be considered a red flag for possible problems.
This approach to evaluating organizations is better than using just a single ratio, since it brings together the effects of multiple items - assets, profits, and market value.