Predicting Bankruptcy through Zeta Model: Explained

In the world of finance, the ability to foresee financial distress is a skill that can make or break investment decisions. Enter the Zeta Model, it has since become an indispensable tool for investors and financial analysts seeking to gauge the financial health of public companies and predict their likelihood of going bankrupt within a two-year timeframe.

 

In this blog, we'll delve into the intricacies of the Zeta Model, exploring its importance for investors and financial analysts, its history, the formula at its core, and the five key financial ratios that drive its predictive power. Additionally, we'll demystify the workings of the Zeta Model, shedding light on how it calculates a company's likelihood of bankruptcy.

 

Understanding Zeta Model

 

The Zeta Model is a mathematical formula that estimates the chances of a public company going bankrupt within a two-year time period. The model was developed by Edward I. Altman, a professor of finance at New York University, and published in 1968. The resulting Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company. The Z-score is considered to be a reasonably accurate predictor of future bankruptcy.

 

The Zeta Model uses multiple corporate income and balance sheet values to measure the financial health of a company and estimate the chances of a public company going bankrupt within a certain time period. The resulting Z-score is considered to be a reasonably accurate predictor of future bankruptcy. Altman's Z-score was found to be 72% accurate in predicting bankruptcy two years before the event, with a Type II error (false negatives) of 6%.

 

Importance of Zeta Model for Investors and Financial analysts

 

Understanding the Zeta Model is important for investors and financial analysts for several reasons. Here are some of the key reasons:

 

1. Predicting bankruptcy risk: The Zeta Model is a mathematical formula that estimates the chances of a public company going bankrupt within a two-year time period. The resulting Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company. This makes the Zeta Model a useful tool for predicting bankruptcy risk, which is important for investors and financial analysts who want to make informed decisions on creditworthiness and investment risk management.

 

2. Assessing financial stability: The Zeta Model is an effective method of predicting the state of financial distress of any organization by using multiple balance sheet values and corporate income. This makes it a useful tool for assessing the financial stability of a company, which is important for investors and financial analysts who want to make informed investment decisions.

 

3. Comparing companies: The Zeta Model can be used to compare the financial health of different companies. This makes it a useful tool for investors and financial analysts who want to compare the financial stability of different companies before making investment decisions.

 

4. Improving accuracy: The Zeta Model improves the accuracy of measuring the financial health of a company and its probability of going bankrupt. This makes it a useful tool for investors and financial analysts who want to make informed investment decisions based on accurate financial data.

 

History of the Zeta Model and its Creator, Edward I. Altman

 

Edward I. Altman, a professor of finance at New York University, developed the Zeta Model in 1968 as a measure of the financial stability of companies. The Z-score formula for predicting bankruptcy was published by Altman in the same year. Altman's work was built upon research by accounting researcher William Beaver and others.

 

Altman created three different Z-scores for different types of businesses, with the original model released in 1968 specifically designed for public manufacturing companies with assets in excess of $1 million. Later in 1983, Altman developed two other models for use with smaller private manufacturing companies.

 

Formula and 5 key Financial Ratios of Zeta Model

 

The Formula for the Zeta Model is:
​

ζ = 1.2A + 1.4B + 3.3C + 0.6D + E

Where:

 

ζ = score

A = working capital divided by total assets

B = retained earnings divided by total assets

C = earnings before interest and tax divided by total assets

D = market value of equity divided by total liabilities

E = sales divided by total assets

 

The Zeta Model formula for predicting bankruptcy is based on five key financial ratios that can be calculated from data found on a company's annual 10-K report. These ratios are:

 

1. Working capital/total assets: This ratio measures the amount of money a company has available to pay off its short-term debts.

 

2. Retained earnings/total assets: This ratio shows the amount of retained earnings or losses in a company. A low ratio indicates that a company is financing its expenditure using borrowed funds rather than funds from its retained earnings.

 

3. Earnings before interest and tax/total assets: This ratio measures a company's profitability and its ability to generate earnings from its assets.

 

4. Market value of equity/total liabilities: This ratio shows how much a company's market value would decline before liabilities exceed assets on the financial statements if it were to become insolvent.

 

5. Sales/total assets: This ratio measures a company's ability to generate sales from its assets. 

 

​How Does the Zeta Model Works in Predicting Bankruptcy

 

The Zeta Model is a mathematical model that estimates the chances of a public company going bankrupt within a two-year time period. The model uses multiple corporate income and balance sheet values to measure the financial health of a company and estimate the chances of bankruptcy. Here is how the Zeta Model works:

 

1. Calculation of financial ratios: The Zeta Model uses five financial ratios that can be calculated from data found on a company's annual 10-K report. These ratios are working capital/total assets, retained earnings/total assets, earnings before interest and tax/total assets, market value of equity/total liabilities, and sales/total assets.

 

2. Weighting of financial ratios: Each of the five financial ratios is assigned a weight based on its relative importance in predicting bankruptcy. The weights are 1.2 for working capital/total assets, 1.4 for retained earnings/total assets, 3.3 for earnings before interest and tax/total assets, 0.6 for market value of equity/total liabilities, and 1 for sales/total assets.

 

3. Calculation of the Z-score: The Zeta Model formula is ζ=1.2A+1.4B+3.3C+0.6D+E, where A is working capital, B is retained earnings, C is earnings before interest and taxes, D is market value of equity, and E is sales. The resulting Z-score uses these five financial ratios to measure the financial health of a company and estimate the chances of a public company going bankrupt within a certain time period.

 

4. Interpretation of the Z-score: The Z-score is considered to be a reasonably accurate predictor of future bankruptcy. A Z-score of less than 1.8 indicates that a company is likely to go bankrupt, while a Z-score of greater than 3 indicates that a company is financially healthy. A Z-score between 1.8 and 3 indicates that a company is in a gray area and requires further analysis.

 

Limitations Of Zeta Model

 

While the Zeta Model is known for its accuracy in predicting bankruptcy, there are some limitations to its effectiveness. Here are some of the limitations of the Zeta Model in predicting bankruptcy:

 

1. Industry-specific: The Zeta Model was originally designed for public manufacturing companies with assets in excess of $1 million. This means that the model may not be as effective in predicting bankruptcy for companies in other industries or with different asset levels.

 

2. Relies on financial statements: The Zeta Model relies on financial statements to predict bankruptcy, which may not always provide a complete picture of a company's financial health. For example, the model does not take into account qualitative factors such as management quality or market conditions.

 

3. Limited time frame: The Zeta Model predicts bankruptcy within a two-year time period. This means that it may not be as effective in predicting long-term financial distress or bankruptcy.

 

4. False positives: While the Zeta Model has a high accuracy rate, it can still produce false positives, which means that it may predict bankruptcy for companies that do not actually go bankrupt. However, the false-positive level is lower compared to other bankruptcy prediction models.

 

Other Prediction Models In Comparison To Zeta Model

 

Here is a comparison of the Zeta Model to other bankruptcy prediction models in terms of accuracy:

 

1. Zeta Model vs. Altman's Z-score: A comparison of the Zeta Model and Altman's Z-score found that the Zeta Model was more accurate in predicting bankruptcy. The Zeta Model had a correct prediction rate of 70% five years prior to bankruptcy, while the Z-score was only 36% accurate.

 

2. Zeta Model vs. Random Forest Model: A study in Turkey found that the Altman Z-Score model had a very high accuracy rate of 95% prior to a year before bankruptcy. However, the study also found that there were only a few studies that applied the Random Forest Model in bankruptcy prediction in Turkey.

 

3. Zeta Model vs. DEA Model: A study in India found that the DEA model had a better predictive accuracy rate of 84-89% in predicting bankrupt firms compared to the LR model.

 

4. Zeta Model vs. Relative Financial Strength System: A study in 1983 compared the Zeta Model with the Relative Financial Strength System published as part of the Value Line Investment Survey. The study found that the Zeta Model was more accurate in predicting bankruptcy.

 

5. False Positive Rate: While the Zeta Model has a high accuracy rate, it can still produce false positives, which means that it may predict bankruptcy for companies that do not actually go bankrupt. However, the false-positive level is lower compared to other bankruptcy prediction models.

 

Overall, the Zeta Model is considered to be a reasonably accurate predictor of future bankruptcy. While there are other bankruptcy prediction models available, the Zeta Model has been found to be more accurate than some of the other models in certain studies.

 

Examples Of Companies Gone Bankrupt Predicted By Zeta Model

 

There are several examples of companies that have gone bankrupt and were predicted by the Zeta Model. Here are some of the examples:

 

1. Enron: Enron was an American energy company that went bankrupt in 2001. The Zeta Model predicted Enron's bankruptcy several years before it actually happened.

 

2. WorldCom: WorldCom was a telecommunications company that went bankrupt in 2002. The Zeta Model predicted WorldCom's bankruptcy several years before it actually happened.

 

3. General Motors: General Motors, the American automobile manufacturer, filed for bankruptcy in 2009. The Zeta Model predicted General Motors' bankruptcy several years before it actually happened.

 

4. Delta Air Lines: Delta Air Lines, the American airline, filed for bankruptcy in 2005. The Zeta Model predicted Delta Air Lines' bankruptcy several years before it actually happened.

 

Conclusion

 

In the intricate landscape of finance, where the stakes are high and the risks ever-present, the Zeta Model stands as a stalwart sentinel, offering valuable insights into the financial health of companies. Developed by the visionary Edward I. Altman, this mathematical formula has proved its mettle as a reliable predictor of bankruptcy, enabling investors and financial analysts to make informed decisions with confidence.

 

Through this exploration, we've unraveled the inner workings of the Zeta Model, its historical significance, the formula that underpins it, and the critical financial ratios that shape its predictive power. We've also touched upon its limitations and compared it to other prediction models, showcasing its effectiveness.

 

In sum, the Zeta Model remains a potent tool, a compass guiding us through the complex world of finance, and a vital asset for those who seek to navigate the treacherous waters of investment with prudence and foresight.