What’s the Financial Viability (Z-Score) of Your Company?

A fundamental step in determining the health of a company is the analysis of its financial statements. Such an analysis can provide a picture of the financial health of a business and a view of the direction the business is heading. An integral part of any such analysis is the calculation of financial ratios – analytical tools applied to financial data.

Liquidity, leverage, activity, profitability and growth are the main areas of focus for ratio analysis. No single ratio calculation will alone provide a meaningful picture of a firm’s financial condition. One financial model, however, attempts to take into account each of the core areas and render a single “score” for the overall viability of a firm. It uses a combination of financial ratios and was developed in 1968 by a Professor Edward Altman of the New York University School of Business.

Mr. Altman developed the “Z-Score” financial model by selecting various financial ratios and applying a weight to each. He developed it by sampling sixty-six publicly traded manufacturing companies that each had assets in excess of $1 million. Professor Altman evaluated twenty-two different ratios that ultimately were reduced to five. He then assigned a weight to each to account for their relative importance to the overall health of the company.

Here is his original Z-Score equation which was designed to predict the overall viability of publicly held manufacturing firms:

Z = 1.2(X1) + 1.4(X2) +3.3(X3) +.6(X4) + .99(X5)

Where:

X1  = Working Capital / Total Assets

X2  = Retained Earnings / Total Assets

X3  = Earnings Before Interest and Taxes / Total Assets

X4  = Market Value Equity / Book Value of Total Debt

X5  = Sales / Total Assets

Z    = Overall Score

For a privately held manufacturer, book value of equity is used rather than the market value of equity. The weightings are also slightly modified. The private company Z-Score calculation is as follows:

Z = .717(X1) + .847(X2) + 3.107(X3) + .42(X4) + .998(X5)

Where:

X1  = Working Capital / Total Assets

X2  = Retained Earnings / Total Assets

X3  = Earnings Before Interest and Taxes / Total Assets

X4  = Book Value of Equity / Book Value of Total Debt

X5  = Sales / Total Assets

Z    = Overall Score

The balance sheet of service and distribution companies are quite different from manufacturers, so Professor Altman modified the formula to more accurately predict the viability of non-manufacturing companies. He did so by eliminating X5 (sales / total assets). The non-manufacturing company Z-Score is calculated as follows:

Z = 6.56(X1) + 3.26(X2) + 6.72(X3) + 1.05(X4)

Whereas,

X1 = Working Capital / Total Assets

X2 = Retained Earnings / Total Assets

X3 = Earnings Before Interest and Taxes / Total Assets

X4 = Book Value Equity / Book Value of Total Debt

Z    = Overall Score

So how is the score interpreted?  Professor Altman concluded that a Z-score in the unhealthy category meant a company had high risk of going bankrupt, whereas a Z-Score in the healthy category represented a stable, healthy company. Those companies that scored in the gray area were considered questionable. Each model has a slightly different interpretation.

Public Manufacturers:          <1.81             Unhealthy

1.81 – 2.99    Undetermined
>2.99             Healthy

Private Manufacturers:         <1.23             Unhealthy

1.23 – 2.90    Undetermined

>2.90             Healthy

Private, Non-manufacturers:                      <1.1           Unhealthy

1.1 – 2.60      Undetermined

>2.6               Healthy

This Z-Score model has gained acceptance by financial professionals, consultants, bankers, investors and various courts of law as a meaningful measure of a company’s viability as an ongoing entity. You should use it as well. Keep in mind, however, that the results are only as good as the underlying data, and no model should be used as the sole basis for evaluation.  q

This article was adopted, with permission, from written works of Jeffrey J. Presogna. Mr. Presogna is a merger and acquisitions professional with Vercor, a multi-office U.S. firm that consults on the purchase, sale and valuation of mid-size private companies.

For a more extensive overview of the Z-score method, go to www.TheBusinessOwner.com, click on ‘Members Only’, enter the password ( it’s “value” for May/June ’05), click ‘Archived Issues’, then May/June ’05 issue