Introduction to the Zeta Model

The sole purpose of the zeta model is to anticipate the likelihood a publicly-traded company will declare bankruptcy in the next two years. The model was developed by Edward Altman, professor at New York University, in 1960. It uses five simple factors to measure the likelihood of bankruptcy on a numeric scale. If a company's "Z-score" is below 1.8, it is likely to go bankrupt within two years. If the z-score is above 3.0, it is very unlikely to declare bankruptcy.

The Model

The Zeta Model is expressed in the following mathematical terms and each of the variables in this expression represents a simple, measurable factor.

  • Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
  • Z stands for Z-score
  • A stands for Working Capital
  • B stands for Retained Earnings
  • C stands for Earnings Before Interest & Taxes (EBIT)
  • D Stands for Total Liabilities
  • E stands for Total Sales

The Factors

The various factors represent measurements of a company's assets. They use the capital, sales, liabilities, and measure the company through debt. Altman believed he could appropriately measure how likely a company is to withstand the market by using the variables in his formula expression. The most valuable factor has the highest coefficient; this means the most valuable factor is EBIT. The least important factor is total liabilities, and this is only given a weight of 0.6. However, it is easy for a company to end up with a low Z-score if the liabilities are high, even though the liability variable is low.

Importance of the Z-Score

The Z-score of a company is constantly changing with its profits and earnings on a given year. Since the model is so simple to calculate, it can be adjusted annually, or even on a term basis. The model is best applied, though, when a company first announces it is going to trade publicly. This gives initial investors a measure of the likelihood of success of an initial investment in the company. The model can also be applied to a period of change in the company. For example, if management is changing, like a merger, measuring a company's z-score can be a worthwhile practice.

Other Measures of Financial Stability

The zeta model is just one used to measure the potential for a company to go bankrupt at a given time. There are more analytical tools, including interest coverage and ratios of returns compared to assets, equity or liquidity. A company's interest coverage is a measure of how easily it can pay down the interest on all current debt arrangements. Essentially, the more easily a company can accomplish this with its current asset base, the less likely the company will move into default on any one of its loans. Loan default is a primary cause of bankruptcy.

Other measures of stability are ratios between returns and underlying factors. For example, a company with high returns when compared to its asset base (ROA) is said to be financially stable. The same is true with a company that has a high return on equity or high return on liquidity.

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