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The Zeta model is a mathematical model that can help you assess the financial health and bankruptcy risk of public companies. The Zeta model, created in 1968 by Professor Edward Altman of New York University, is based on a number of financial statistics that assess several facets of a company's performance.
The Zeta model can generate a single number, known as the Z-score or Zeta score, that represents the likelihood that a business will fail within the following two years. The likelihood of bankruptcy is inversely correlated with Z-score, and vice versa.
The Zeta model uses the following formula to calculate the Z-score:
\begin{aligned}
&\zeta = 1.2A + 1.4B + 3.3C + 0.6D + E\\
&\textbf{where:}\\
&\zeta=\text{score}\\
&A = \text{working capital divided by total assets} \\
&B = \text{retained earnings divided by total assets}\\
&C = \text{earnings before interest and tax divided by total assets}\\
&D = \text{market value of equity divided by total liabilities}\\
&E = \text{sales divided by total assets}\\
\end{aligned}
The Z-score can be interpreted using the following zones of discrimination:
- Z > 2.99 -“Safe” Zone: The company is unlikely to go bankrupt in the next two years.
- 1.81 < Z < 2.99 -“Grey” Zone: The company is in a state of financial distress and bankruptcy is possible but not certain.
- Z < 1.81 -“Distress” Zone: The company is highly likely to go bankrupt in the next two years.
The Zeta model has undergone testing and validation on numerous samples of publicly traded businesses and has demonstrated a high level of accuracy in forecasting bankruptcy. Altman (2000) claims that the Zeta model's ability to accurately predict bankruptcy has ranged from more than 95% one period before bankruptcy to 70% over a string of five prior annual reporting periods.
The Zeta model has some limitations and assumptions that should be considered when applying it to real-world situations. First of all, the model was created with publicly traded manufacturing companies in mind and might not be appropriate for other business models or sectors. Second, the model makes the potentially incorrect assumption that the financial ratios are independently distributed and have a normal distribution. Third, the model ignores aspects like market conditions, rivalry, regulations, etc. that may have an impact on a company's performance. Fourth, because it is based on historical data, the model might be unable to account for the dynamic changes in a company's financial status over time.
As a result, rather than replacing other financial analysis techniques, the Zeta model should be utilized in addition to them. The Zeta model can be a helpful tool for determining a company's financial stability and risk of bankruptcy, but it should not be interpreted as a final judgment or suggestion. The Zeta model cannot advise you on what steps to take or what results to anticipate, but it can assist you in identifying potential issues and opportunities in a company's performance.
