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  Z Score Models

Introduction to Z- Score Models

Altman was the first who build up a model (in year 1968), by using financial ratios, which was capable to predict financial failure. In year 2000 he revised that model. Actually, the revisions essential to make the model effectual in present times were quite minor. The revised model of Altman, the Z-score model, is relies on five financial ratios and is as follows:

Z = 0.717a + 0.847b + 3.107c + 0.420d + 0.998e

where a stands for = Working capital/Total assets

b stands for = Accumulated retained profits/Total assets

c stands for = Operating profit/Total assets

d stands for = Book (statement of financial position) value of ordinary and preference shares/Total liabilities at book (statement of financial position) value

e stands for = Sales revenue/Total assets

The coefficients (the numbers) in the above model imitate the significance to the Z-score of every of the ingredients (a to e).

While developing and revising this model, Altman performed experiments by using a paired sample of failed businesses and non-failed businesses and collected appropriate data for each business for five years prior to failure. He established that the model presented through the formula above was capable to predict failure for up to two years before it happened.

Though, the predictive correctness of the model became weaker the longer the time before the date of the actual failure.

The ratios employed in this model were recognized through Altman by a process of trial and error, because there is no underlying theory of financial failure to assist guide researchers in their selection of suitable ratios. As per to Altman, those businesses with a Z-score of less than 1.23 be apt to fail. The lower the score the bigger is the possibility of failure. Those with a Z-score greater than 4.14 tend not to fail. Those businesses with a Z-score among 1.23 and 4.14 occupied a 'zone of ignorance' and were hard to classify. Though, the model was able generally to classify 91 per cent of the businesses accurately; only 9% fell into the 'zone of ignorance'. Altman based his model on US (united state) businesses.

In current years, other models, using an identical approach, have been built up during the world. In the UK (United Kingdom), Taffler has built up separate Z-score models for dissimilar types of business. The prediction of financial failure is not the single area in which research into the predictive ability of ratios has occurred. Researchers have also built up ratio-based models which claim to assess the vulnerability of a business to takeover through another. This is other area that is of vital significance to all those related with the business.

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