Zeta model
The term refers to a mathematical model that is used to estimate the probability of a company going bankrupt in the next two years. The output of the model is a z-score, which presents a score on the scale of 0 to 4, where the larger score indicates a lower chance of bankruptcy.
The Zeta Model, devised by Edward I. Altman, a finance professor at New York University, is a mathematical model designed to assess the likelihood of a public company facing bankruptcy within a two-year timeframe. The numerical output generated by this model is termed the company’s Z-score (or zeta score), and it is widely regarded as a fairly precise indicator of prospective financial distress.
Introduced in 1968, the Z-score utilises various financial metrics derived from a company’s income statement and balance sheet to gauge its overall financial well-being.
Z-score formula
The foundation of the Z-score model lies in five pivotal financial ratios, drawing upon information found in the 10-K report. This incorporation enhances the model’s precision in evaluating a company’s financial well-being and the likelihood of bankruptcy.
The formula for Altman’s Z-score is expressed as follows:
ζ = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
Where:
Zeta (ζ) – is the Altman’s Z-score
A – is the Working Capital/Total Assets ratio
B – is the ratio of Retained Earnings to Total Assets
C – is the Earnings Before Interest and Tax/Total Assets ratio
D – is the ratio of Market Value of Equity to Total Liabilities
E – is the Total Sales/Total Assets ratio
The Zeta Model provides a singular numeric output known as the z-score (or zeta score), offering a representation of a company’s probability of facing bankruptcy within the upcoming two years. A lower z-score signifies a higher likelihood of bankruptcy. The Zeta model’s accuracy in predicting bankruptcies ranges from over 95% one period before bankruptcy to 70% over a series of five preceding annual reporting periods.
Z-scores are categorized into zones of discrimination, indicating the likelihood of a company going bankrupt. A z-score below 1.8 suggests a probable bankruptcy, while scores exceeding 3.0 indicate that bankruptcy is unlikely within the next two years. Companies with z-scores falling between 1.8 and 3.0 reside in a gray area, with an equal likelihood of bankruptcy or financial stability.
