Predicting Corporate Bankruptcy: The Z-Score Model1

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Part III Risk
Appendix 30A Predicting Corporate Bankruptcy:
The Z-Score Model1
Many potential lenders use credit scoring models to assess the creditworthiness of prospec-
tive borrowers. The general idea is to fi nd factors that enable the lenders to discriminate be-
tween good and bad credit risks. To put it more precisely, lenders want to identify attributes
of the borrower that can be used to predict default or bankruptcy.
Edward Altman has developed a model using fi nancial statement ratios and multiple
discriminant analyses to predict bankruptcy for publicly traded manufacturing fi rms. The
resultant model is of the form
EBIT
New working capital
Z 3.3

__________
_________________

1.2




Total assets
Total assets
Sales
Market value of equity
1.0

__________
___________________

.6




Total assets
Book value of debt
Accumulated retained earnings
1.4




__________________________
Total assets
where Z is an index of bankruptcy.
.com/rwj

A score of Z less than 2.675 indicates that a fi rm has a 95 percent chance of becoming
bankrupt within one year. However, Altman’s results show that in practice scores between
.mhhe
1.81 and 2.99 should be thought of as a gray area. In actual use, bankruptcy would be pre-
dicted if Z 1.81 and nonbankruptcy if Z 2.99. Altman shows that bankrupt fi rms and
nonbankrupt fi rms have very different fi nancial profi les one year before bankruptcy. These
different fi nancial profi ts are the key intuition behind the Z-score model and are depicted in
Table 30A.1.
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Table 30A.1
Average Ratios One Year before
Financial Statement
Bankruptcy of
Ratios One Year
Bankrupt Firms
Nonbankrupt Firms
before Bankruptcy:
Net working capital
Manufacturing Firms




_________________

6.1%
41.4%
Total assets
Accumulated retained earnings





__________________________
62.6%
35.5%
Total assets
EBIT


__________

31.8%
15.4%
Total assets
Market value of equity




___________________

40.1%
247.7%
Total liabilities
Sales


______

150%
190%
Assets
SOURCE: Edward I. Altman, Corporate Financial Distress and Bankruptcy (New York: John Wiley & Sons,
1993),Table 3.1, p. 109.
1Edward I. Altman, Corporate Financial Distress and Bankruptcy (New York: John Wiley & Sons, 1993), Chapter 3.
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Altman’s
original
Z-score model requires a fi rm to have publicly traded equity and be
a manufacturer. He uses a revised model to make it applicable for private fi rms and non-
manufacturers. The resulting model is this:
Net working capital
Accumulated retained earnings
Z 6.56

__________________________


________________
3.26





Total assets
Total assets
Book value of equity

EBIT
1.05

__________
_________________

6.72





Total assets
Total liabilities
where Z 1.23 indicates a bankruptcy prediction,
1.23 Z 2.90 indicates a gray area,
and Z 2.90 indicates no bankruptcy.
U.S. Composite Corporation is attempting to increase its line of credit with First National State
Bank. The director of credit management of First National State Bank uses the Z-score model to de-
termine creditworthiness. U.S. Composite Corporation is not a publicly traded fi rm, so the revised
Z-score model must be used.
EXAMPLE

The balance sheet and income statement of U.S. Composite Corporation are in Tables 2.1 and
2.2 (Chapter 2).

The fi rst step is to determine the value of each of the fi nancial statement variables and apply
them in the revised Z-score model:
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(in millions)
Net working capital
275




_________________



_____

0.146
.mhhe
Total assets
1,879
Accumulated retained earnings
390





__________________________


_____
0.208
Total assets

1,879
EBIT
219


__________



_____
0.117
Total assets

1,879
Book value of equity
805





_________________



____
1.369
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Total liabilities
588
The next step is to calculate the revised Z-score:
Z 6.56 0.146 3.26 0.208 1.05 0.117 6.72 1.369
10.96
Finally we determine that the Z-score is above 2.9, and we conclude that U.S. Composite is a good
credit risk.
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