Z-Score: Measuring Financial Health
According to the American Bankruptcy Institute, almost 48,000 businesses in the United States filed for bankruptcy in 2011. Although bankruptcy numbers are down from 2010, a significant number of firms involved in transactions with these companies also suffered financial losses. To protect the financial stability of their own businesses against the potential insolvency of customers, many firms use what is called the “Z-Score Model of Financial Health” in credit analysis.
Dr. Edward Altman, a financial economist, developed the Z-Score for his doctoral dissertation. He first published an article about the statistical model in 1968 for an academic journal and by the mid-1980s credit managers, analysts and AR professionals were using the Z-Score to evaluate prospective and existing customers’ probability of filing for bankrupty.
The Z-Score formula takes ratios of five common business metrics, then mulitplies each by a certain percentage, then adds them together. The resulting total or “score” indicates the likelihood of bankruptcy. In the original sample, the model’s accuracy at two years prior to failure was 72 percent, according to Dr. Altman’s article, “The Use of Credit Scoring Models and the Importance of a Credit Culture.”
Altman’s Z-Score can be ...