The Z-score formula for predicting bankruptcy is an application of discriminant analysis. The Z-score is a linear combination of four or five common business ratios, weighted by coefficients .
The formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company.
The discriminant function is
Where X1= Working Capital/Total Assets(%)
X2= Retained Earnings/Total Assets(%)
X3=EBIT/Total Assets (%)
X4= Market Value Of Equity/Book Value Of Debt(%)
X5= Sales to Total Assets(times)
The firm is classified as financially sound if Z>2.99 and financially distressed if Z<1.81.
The model is based on two important concepts of corporate finance—operating leverage and asset utilization. Lenders are aware of the pitfalls of financing firms with high operating leverage and low asset utilization. It is noteworthy that the model has total assets as the denominator in four out of the five variables. However , the Z-score model makes two basics assumptions. One that the firm’s equity is publicly traded and second, that it is a firm engaged in manufacturing activities.