Edward Altman, a professor at New York University, created the Z score model. The Z score model is a mathematical formula to determine the likelihood of a business going into bankruptcy. By using an audited financial statement, the Z score is calculated in the following manner:
0.012 (working capital / total assets) + 0.014 (retained earnings / total assets) + 0.033 (earnings before interest and taxes / total assets) + 0.006 (market value of equity/ total of liabilities) + .999(sales / total assets)
Z scores of 3 or more are sound companies, unlikely to go into bankruptcy. Scores that are lower than 3 but above 2.7 should be considered low risk, but still should be approached with caution. Scores lower than 2.7 are considered at high risk in the next two years for bankruptcy, while those lower than 1.8 are considered to be in immediate risk.
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