This technical article was written primarily for our financially astute readers. Because of the complexity of Z-scoring and analysis, we recommend this method be used only by credit professionals in your firm.
Numerous studies have been conducted of failed businesses to determine if certain ratios can predict business failure 2 to 3 years in advance of actual bankruptcy. The most well-known and frequently used method is the “Z-score” which incorporates five weighted ratios into a single number. Most larger banks have Z-score calculations built into their financial statement spreadsheet programs, so it’s a good calculation to understand in reference to your own company, as well as a tool to help you avoid bad debts with your largest and/or riskiest customers.
Z-scores are based on five ratios:
1. Working Capital to Total Assets
2. Accumulated Retained Earnings to Total Assets
3. Net Profit Before Taxes Plus Interest Expense to Total Assets
4. Net Worth to Total Liabilities
5. Net Sales to Total Assets
Each of these ratios is given a weighting based on the relationship of the number to the value it plays in determining future bankruptcy. The weightings are as follows:
Ratio # Weighting
1 1.2
2 1.4
3 3.3
4 0.6
5 1.0
Based on exhaustive data from postmortem companies, researchers determined that Z-scores of 3.0 and above indicate a very healthy company, scores of 1.80 to 2.99 should be cause for concern, and less than 1.8 could indicate a bankruptcy candidate within the coming few years. As with all financial analysis, trends are extremely important as are the root causes for a low Z score rating.
As one technical journal described Z-scores so aptly – it’s a bit like going to the doctor for your annual exam and finding out that you received a physical exam rating of 2.84 when last year you had a 3.03. Obviously, you’re still above the 1.80 impending death, but you’d probably want a few more details to know why your rating went down and what it means!
Let’s look at an example of a sample family business and walk through a Z-score calculation. ABC Co.’s financial statement has the following data:
Net Sales $7,000,000
Net Profit Before Tax 75,000
Interest Expense 80,000
Current Assets 1,350,000
Total Assets 2,500,000
Current Liabilities 1,100,000
Total Liabilities 1,875,000
Net Worth $625,000
Given these results, ABC Company’s Z-score would be calculated as follows:
1. Working Capital to Total Assets: (1,350,000-1,100,000)/2,500,000 = 0.1
2. Net Worth to Total Assets: 625,000/2,500,000 = 0.25
3. Net Profit Before Tax + Interest to Total Assets: (75,000 + 80,000)/2,500,000 = 0.06
4. Net Worth to Total Liabilities: 625,000/1,875,000 = 0.33
5. Net Sales to Total Assets: 7,000,000/2,500,000 = 2.80
Now we must weigh the Z ratios:
Ratio Z Weighting Total
0.10 1.2 0.12
0.25 1.4 0.35
0.06 3.3 0.20
0.33 0.6 0.20
2.80 1.0 2.80
Final Z Score 3.67
Based on this data, we can confirm that this company is not in danger of failing.
Let’s manipulate the numbers a bit and assume this company has more debt (i.e. more leverage) and fewer sales. Assume the following:
Net Sales $5,000,000
Net Profit Before Tax 35,000
Interest Expense 120,000
Current Assets 1,350,000
Total Assets 3,000,000
Current Liabilities 1,100,000
Total Liabilities 2,700,000
Net Worth 300,000
The Z-score with this company would be 2.09 which is in the “watch closely” Z-score range.
Is it worth your time and energy to compute Z-scores on your own company? Yes, definitely. On your customers? Maybe. The Z-score simply gives you one more tool to make a good credit decision on large or questionable accounts — a tool that could save you thousands of dollars in bad debt expenses later.
