Wondering what a Z-Score is? Well, it’s basically an estimation of the number of standard deviations a point is away from the mean of its data set. It’s sometimes called standard score, and overall it means that it measures the standard deviations a data point is below or above the mean population.
Its use is to compare the data points from multiple data sets in order to find correlations. The score can either result in zero, positive or negative. A zero score indicates that it’s average, so it’s the same as the mean. A negative one shows how far below the mean a point is on the distribution curve. A positive one shows how far above the mean a point is on it.
Would you like to know more about this concept? If that’s the case, keep reading, because you will find the information you were looking for.
Dr. Edward Altman was the one who adapted the concept to the world of business and financing, as he used it to predict if a company will go bankrupt. His calculation is called the Altman Z-Score, and it sums several weighted financial ratios and compares it to a graded scale. If the score is low, the firm is more likely to declare bankruptcy.
The Z-Score is very important, as it estimates how financially strong a firm is considering it relies on several different metrics. Most of the times it’s used for investors to calculate a company’s solvency and determine if it’s a good idea to sell or buy an investment.
If a Z-Score is low, it shows that the company is close to insolvency or bankruptcy, so a company with a lower score is a high-risk investment.
You should be aware of the fact that this measurement doesn’t work for new companies, the reason being their earnings, which are too low. In the Altman score calculation, low earnings have a negative effect on most of the ratios used in it. Therefore, new companies have a tendency of having a low Altman score.
Moreover, the formula doesn’t reflect cash flows. If a profitable company has poor cash flow, for instance, it might not be able to pay its liabilities, and it leads to them having to declare bankruptcy.
Also, you should keep in mind that the Z-Score is not meant to calculate when a firm will file bankruptcy. It’s rather meant to measure how close a firm resembles another that has become insolvent. The model is criticized as it utilizes unexplained accounting information. Although it is criticized, the Z-Score remains one of the most used calculations of a firm’s financial health.
What Is the Formula?
The Z-Score formula should look like this:/
The Altman Z-Score equation is calculated like this:
So, there you have it, the information about the Z-Score and its formula. You should now be more familiar with the term.