What is a 'Z-Score'
A Z-score is a numerical measurement of a value's relationship to the mean in a group of values. If a Z-score is 0, it represents the score is identical to the mean score.
Z-scores may also be positive or negative, with a positive value indicating the score is above the mean and a negative score indicating it is below the mean. Positive and negative scores also reveal the number of standard deviations the score is either above or below the mean.
BREAKING DOWN 'Z-Score'
Z-scores also reveal to statisticians and traders if a score is typical for a specified data set or if it is atypical. In addition to this, Z-scores also make it possible for analysts to adapt scores from various data sets to make scores that can be compared to one another accurately. Usability testing is one example of a real-life application of Z-scores.
This term is more commonly known as the Altman Z-score. Edward Altman, a professor at New York University, developed and introduced the Z-score formula in the late 1960s as a solution to the time-consuming and somewhat confusing process investors had to undergo to determine how close to bankruptcy a company was. In reality, the Z-score formula Altman developed ended up providing investors with an idea of the overall financial health of a company.
The Altman Z-Score Formula
The Altman Z-score is the output of a credit-strength test that helps gauge the likelihood of bankruptcy for a publicly traded manufacturing company. The Z-score is based on five key financial ratios that can be found and calculated from a company's annual 10K report. The calculation used to determine the Altman Z-score is as follows:
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
In this equation:
A = Working capital/total assets
B = Retained earnings/total assets
C = Earnings before interest and taxes (EBIT)/total assets
D = Market value of equity/total liabilities
E = Sales/total assets
Typically, a score below 1.8 indicates that a company is likely heading for or is under the weight of bankruptcy. Conversely, companies that score above 3 are less likely to experience bankruptcy.
Altman Z-Score Plus
Altman developed and released the Altman Z-Score Plus in 2012. This formula is used to evaluate both public and private companies and can be used for non-manufacturing companies as well as manufacturing companies. The Z-Score Plus is suitable for companies in the United States as well as companies outside of the United States.