The Z-Score … or ZZZ-score

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A recent Supply Chain Digest piece on what are the best ways to estimate supplier financial risk? noted that while multiple methods may be needed to see the complete picture, the Altman Z-Score is one of the best, if not the best, predictor of bankruptcy risk. In other words, the lower your score, the more likely your firm will be the next to go to financial sleep.

As per investopedia and wikipedia, the Z-score is a model that combines (four or) five different financial ratios to determine the likelihood of bankruptcy using weighted multipliers calculated against refined statistical models. Studies have shown it to be more than 70% accurate in predicting corporate bankruptcies two years prior to Chapter 7 filing.

The relevant ratios combined in the standard Z-score are:

    • (T1) Working Capital / Total Assets
    • (T2) Retained Earnings / Total Assets
    • (T3) Earnings Before Interest and Taxes / Total Assets
    • (T4) Market Value of Equity / Total Liabilities
    • (T5) Sales / Total Assets

And the calculation is: Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.999T5

And it makes sense. With this model, a firm is likely on the edge of bankruptcy if:

  • its total asset to EBITDA is high
    which means it’s earnings aren’t enough to sufficiently maintain it’s assets and cover it’s operating expenses
  • its total asset to retained earnings ratio is high
    which means the bank balance is shrinking (and possibly doing so rapidly)
  • its total asset to working capital ratio is high
    which means it doesn’t have enough working capital free to effectively conduct business
  • its total asset to sales ratio is high
    which means it’s not bringing in enough new business
  • its total liability to market value (of equity) is high
    which means that its investments are actually generating losses

Thus, before you enter into an agreement with a (new) supplier for a critical part or service, you should get its financial information and calculate this score. If it’s in the grey area, be sure to hedge your risk. And if it’s low, unless you’re prepared to finance the supplier or even buy it out, run for the hills!

P.S. A recent article on the ISM site describing watch points on supplier health contains a sample calculation.