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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 prospective borrowers. The general idea is to nd factors that enable the lenders to discriminate between 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 nancial statement ratios and multiple discriminant analyses to predict bankruptcy for publicly traded manufacturing rms. The resultant model is of the form Z EBIT 3.3 __________ Total assets Sales 1.0 __________ Total assets New working capital 1.2 _________________ Total assets Market value of equity .6 ___________________ Book value of debt

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Accumulated retained earnings 1.4 __________________________ Total assets where Z is an index of bankruptcy. A score of Z less than 2.675 indicates that a rm has a 95 percent chance of becoming bankrupt within one year. However, Altmans results show that in practice scores between 1.81 and 2.99 should be thought of as a gray area. In actual use, bankruptcy would be predicted if Z 1.81 and nonbankruptcy if Z 2.99. Altman shows that bankrupt rms and nonbankrupt rms have very different nancial proles one year before bankruptcy. These different nancial prots are the key intuition behind the Z-score model and are depicted in Table 30A.1.

Table 30A.1
Financial Statement Ratios One Year before Bankruptcy: Manufacturing Firms

Average Ratios One Year before Bankruptcy of Bankrupt Firms Net working capital _________________ Total assets Accumulated retained earnings __________________________ Total assets EBIT __________ Total assets Market value of equity ___________________ Total liabilities Sales ______ Assets 6.1% 62.6% 31.8% 40.1% 150% Nonbankrupt Firms 41.4% 35.5% 15.4% 247.7% 190%

SOURCE: Edward I. Altman, Corporate Financial Distress and Bankruptcy (New York: John Wiley & Sons, 1993),Table 3.1, p. 109.

Edward I. Altman, Corporate Financial Distress and Bankruptcy (New York: John Wiley & Sons, 1993), Chapter 3.

Altmans original Z-score model requires a rm to have publicly traded equity and be a manufacturer. He uses a revised model to make it applicable for private rms and nonmanufacturers. The resulting model is this: Z Net working capital 6.56 ________________ Total assets EBIT 1.05 __________ Total assets Accumulated retained earnings 3.26 __________________________ Total assets Book value of equity 6.72 _________________ 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.

EXAMPLE

(in millions) Net working capital _________________ Total assets Accumulated retained earnings __________________________ Total assets EBIT __________ Total assets Book value of equity _________________ Total liabilities The next step is to calculate the revised Z-score: Z 6.56 0.146 10.96 3.26 0.208 1.05 0.117 6.72 1.369 275 _____ 1,879 390 _____ 1,879 219 _____ 1,879 805 ____ 588 0.146 0.208 0.117 1.369

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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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 determine creditworthiness. U.S. Composite Corporation is not a publicly traded rm, so the revised Z-score model must be used. The balance sheet and income statement of U.S. Composite Corporation are in Tables 2.1 and 2.2 (Chapter 2). The rst step is to determine the value of each of the nancial statement variables and apply them in the revised Z-score model: