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Chapter 12

Corporate failure prediction models

Quantitative and qualitative models exist.

2.1 The Z score – a key quantitative model

 Uses financial information to predict if an organisation is likely to fail within a two
year period.

 Is generated from the sum of five weighted ratios:

Z score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Ratios Interpretation

X1 = working capital/total assets  Z score less than 1.81:
Organisation in danger of
X2 = retained earnings/total assets failure within a 2 year period

X3 = EBIT  Z score 1.81 – 2.99:
Further investigation needed to
X4 = MV equity/total liabilities assess likelihood of failure

X5 = sales/total assets  Z score more than 3:

Organisation financially sound
and expected to survive

In the exam it is more likely that you will be asked to comment on
the results of a calculation that has been done, rather than carrying
out detailed calculations.

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