Understanding the Zeta Model
I'm here to explain the Zeta Model, which predicts the likelihood of a public company going bankrupt within two years. You should know this is a straightforward mathematical tool that gives you a Z-score, also called the zeta score, and it's proven to be a solid predictor of bankruptcy.
What the Zeta Model Is
Let me tell you directly: the Zeta Model is a mathematical model that estimates the chances of a public company going bankrupt within a two-year period. The Z-score it produces comes from multiple values on a company's income statement and balance sheet, measuring its overall financial health. This model was published in 1968 by Edward I. Altman, a finance professor at New York University.
Key Takeaways
- The Zeta Model estimates bankruptcy chances for public companies over a specific time frame.
- It was developed by NYU professor Edward Altman in 1968.
- The Z-score uses corporate income and balance sheet data to assess financial health.
The Formula for the Zeta Model
Here's the formula you need: ζ = 1.2A + 1.4B + 3.3C + 0.6D + E, where ζ is the score, A is working capital divided by total assets, B is retained earnings divided by total assets, C is earnings before interest and tax divided by total assets, D is market value of equity divided by total liabilities, and E is sales divided by total assets. Plug in your company's numbers, and you'll get the Z-score.
What the Zeta Model Tells You
The model gives you a single number, the Z-score, which shows the likelihood of bankruptcy in the next two years. A lower score means higher risk. Studies show its accuracy is over 95% one period before bankruptcy, dropping to 70% over five prior periods.
These Z-scores fall into zones: if it's above 2.99, you're in the safe zone; between 1.81 and 2.99 is the grey zone where bankruptcy is equally likely; below 1.81 puts you in the distress zone. Originally for public manufacturing companies, the model has versions for private firms, small businesses, non-manufacturers, and emerging markets.
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