Credit Suisse’s Zeta & Why You Need to Know About It
Zeta Mode, or the Zeta Credit Risk Model, is a very useful model to estimate the default risk of a company in 2 years. The Z-score medal was designed to analyse the financial health of the manufacturing industry. The model takes the balance sheets of bankrupted companies as samples and calculates the few ratios that can best reflect a firm's financial situation. It weights components differently to predict a firm's short term default risk. With high accuracy of over 70%, it drove people to adapt the model to other industries by introducing a series of new factors, eliminating old ones, and adjusting the weighting.
Here's the model equation:ζ = 1.2A+1.4B+3.3C+0.6D+E
(A,B,C, D and E each represent different financial values)
💡A is the working capital divided by total assets, representing the firm's liquidity. Low A value signals the company is facing low liquidity and may have cash flow disruptions. The firm's very likely to go bankrupt if such a situation occurs because it often comes with the inability to repay debt.
💡B represents retained earnings divided by total assets. It is the net profit of the company after giving out dividend payments to its shareholders. It shows the ability of the company to pay dividends stably- the higher the value of B is, the more confident the shareholders are about the company. In volatile markets, a stable dividend payment is almost an adrenaline pump to investors.
💡C represents Earnings before tax and income(EBIT) divided by Total Liability. The value estimates the profitability of company capital, which essentially is the ability of the company to make profit and how much they need to invest in to generate profit.
💡D is the Market Value of Equity divided by Total Liability (sum of debts). It predicts the condition of the company's financial structure. It is worth noting that D has the lowest coefficient in the equation.
💡E is Sales divided by Total Assets which is the company's ability to generate revenue with its asset.
The higher the Z-score, the safer the company is financially. A Z-score above 2.99 is regarded as the safe zone; between 1.81 to 2.99 is the grey zone but a Z-score under 1.81 is the distress zone. This may vary slightly across different industries but it's a good practice to factor in the structure and the development strategy of a company.
The model has been adapted to suit different industry's needs. For instance, the coefficient for variable A is up to 6.56 for unlisted companies that are not in the manufacturing industry.
But the model is not applicable to the banking and financial industry because of the nature of business. The Zeta model drove the development of financial warning system models and allowed different sectors to be better regulated.
However, we cannot solely rely on the z-score for investment decisions, warranting more in-depth analysis and due diligence.
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