The Zeta Model is a mathematical tool engineered to evaluate the probability of a public company experiencing bankruptcy within a span of two years. This model generates a numerical Z-score (or zeta score), which serves as a relatively accurate predicter of future financial distress.
First introduced in 1968 by Edward I. Altman, a renowned finance professor from New York University, the Z-score is calculated using several parameters from a company’s income statement and balance sheet, measuring overall corporate health.
Key Takeaways
- The Zeta Model evaluates the probability of bankruptcy for public companies within a specified time frame.
- Introduced by Edward Altman in 1968, the model leverages various financial metrics.
- The resulting Z-score assesses the financial stability of a company.
The Formula for the Zeta Model
Below is the formula for calculating the Z-score:
[\zeta = 1.2A + 1.4B + 3.3C + 0.6D + E]
Where: \((\zeta)\) = Score \((A)\) = Working capital divided by total assets \((B)\) = Retained earnings divided by total assets \((C)\) = Earnings before interest and tax divided by total assets \((D)\) = Market value of equity divided by total liabilities \((E)\) = Sales divided by total assets
What Does the Zeta Model Tell You?
The output of the Zeta Model, the Z-score, provides a straightforward metric to gauge the risk of bankruptcy within the next two years. Lower Z-scores denote a higher likelihood of bankruptcy. The model’s accuracy varies between 95% one period before a bankruptcy event and 70% over five preceding annual reporting periods.
Z-scores fall into specific zones, indicating the risk probability:
- Safe Zone: ( Z > 2.99 ) - Bankruptcy is unlikely.
- Gray Zone: ( 1.81 < Z < 2.99 ) - Uncertainty prevails, and bankruptcy might or might not occur.
- Distress Zone: ( Z < 1.81 ) - High likelihood of impending bankruptcy.
Different iterations of the Z-score formula cater to diverse segments, including private companies, emerging markets, and non-manufacturing sectors, enhancing its versatility.
Edward Altman’s introduction of the Zeta Model catered primarily to publicly traded manufacturing entities. Subsequent adaptations have broadened its applicability to privately-held companies, small enterprises, non-manufacturers, and firms in emerging markets.
Related Terms: bankruptcy, corporate finance, financial ratios, credit risk.
References
- NYU Stern. “Predicting Financial Distress of Companies: Revisiting the Z -Score and Zeta® Models”, Page 32.
