9.21 Altman’s Corporate Credit Scoring System
In the early 1960s, Dr. Edward Altman of NYU used “Multiple Discriminant Analysis,” combining a set of 5 financial ratios to come up with the “Z-Score.” This score assesses a company’s probability of failure or bankruptcy, using 8 variables from a company’s financial statements. The formula, including five ratios and their coefficients, follows.
It is notable that the principal ratio, i.e., the one with the largest coefficient is ROA (EBIT / TA)!
Z =
3 (EBIT / TA)
+ 1.4 (RE / TA)
+ 1.2 (WC / TA)
+ 1.0 (S / TA)
+ 0.6 (MV-Eq. / BV-Debt)
Code:
| TA | Total Assets | WC | Working Capital = Current Assets less Current Liabilities |
| EBIT | Earnings before Interest and Taxes | Sales | Sales |
| RE | Retained Earnings | MV- Eq | Market Value of Firm’s Equity |
| BV- Debt | Book Value of Firm’s Debt |
Interpreting the Z Score:
Z-SCORE ABOVE 3.0 –The company is OK, according to these data.
Z-SCORE BETWEEN 2.7 and 2.99 – Alert. One should exercise caution.
Z-SCORE BETWEEN 1.8 and 2.7 – There is a high probability that the company will go bankrupt within 2 years of the date of the given financial figures.
Z-SCORE BELOW 1.80 – Probability of failure is very high.
