By James Bell
The Zeta Model helps us determine if a public company will declare bankruptcy in the next 2 years. It was first published in 1968 by NYU Finance Professor Edward L. Altman. This model assigns a score based on various weighted metrics. These metrics combine balance sheet and income statement items to look at the overall financial health of a company. It can describe a company in financial distress. This is when a company is struggling to pay debt payments which often precipitates bankruptcy. A company need not actually be in default to be in financial distress. This score assists you in understanding this risk.
Edward Altman built this multivariate model based on previous work on univariate models. William Beaver notably applied t-tests to univariate accounting ratios in Bankruptcy Prediction Model in 1967 (Beaver 1967). Altman took this a step further. He applied a similar line of thinking to multiple combinations of accounting ratios and published his famous work described here. Later, in 1980, John Ohlin took this work a step further using Logit Regression on a much larger sample. Citations are included at the end of this article.
Where:
= Zeta
= Total Assets/Sales
= Total Liabilities / Market Value of Equity
= Total Assets/ Earnings before Interest & Tax
= Total Assets/Retained Earnings
= Total Assets/ Working Capital
This cool symbol is the 7th letter of the Greek alphabet called Zeta. You’ll see this often referred to as simply Z or Z-Score for short. Remember, the Z-score here is different than what you’ll encounter in your basic statistics course when you go over normal distributions.
To start, we have a top line income statement item, Sales, and divide it by a balance sheet item, Total Assets. This is also called the Asset to Sales Ratio or Asset Turnover. This helps us understand how well a company can generate sales with its assets. Higher numbers are more favorable.
This part includes 2 balance sheet items. This is also called the Debt to Equity Ratio. Note that Market Value of Equity does not always equate to the Book Value of Equity. Market Value of Equity is the same as Market Capitalization. If you don’t have the Market Cap, you can take numberof shares
times share price to calculate it.
We have a balance sheet and an income state item in this part. It’s pretty straight forward but could be confused with similar accounting metrics. For instance, this could be mistaken for Return on Assets (ROA) or Return on Total Assets (ROTA). While these ratios are similar, Zeta Model uses EBIT rather than Net Income.
Here we have 2 balance sheet items that we divide to get another ratio. This helps us understand the companies reliance on debt. A lower number here indicates that funding is fueled more by debt than from retained earnings. The lower the number, the increased likelihood of failure to pay debt payments which could precipitate or cause bankruptcy.
We define Working Capital as Current Assets – Current Liabilities. This is a liquidity measure of a companies near term health. A low or negative number typically indicates that a company is struggling to pay it’s short term obligations, such as payroll and interest. Struggling to make these types of payments is an indicator of a company in poor financial health.
As with any metric, we rely on our assumptions and calculations to surface information that was once was just data. If the underlying financial data is inaccurate or falsely stated, our Zeta model will lose it’s usefulness. No single metric is perfect but this is one tool that you can use in combination with others to help make better decisions and allocate resources more effectively.
Altman, Edward I (1968). “Financial ratios, discriminant analysis and the prediction of corporate bankruptcy”. Journal of Finance. 23 (4): 589–609.
Beaver, W. (1967), “Financial Ratios as Predictors of Failures,” in Empirical Research in Accounting, 4 (Supplement), p. 71-111.
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