5.17 Credit Ratings: Going Concern or Distressed

Besides price ratios, an important part of any evaluation is also to assess whether a company is a going concern or a distressed firm.   One way of approaching this problem is to develop a scoring system that is designed to measure the probability of a firm going bankrupt.  This approach was adopted by Altman (1968), who developed what has become known as “Altman’s Z-Score.”  This is easy to calculate from traditional financial ratios and provides a measure for the possibility of bankruptcy within 2-years.

Altman Z-Score

Z = 1.2R1 + 1.4R2 + 3.3R3 + 0.6*R4 + 0.999*R5

Where the accounting ratios are defined as follows:

R1 = Net working capital /Total assets

R2 = Retained Earnings/Total Assets

R3 = EBIT/Total Assets

R4 = Shareholders’ Equity/Total Liabilities or Market Value of Equity/Total Liabilities

R5 = Sales/Total Assets

 

Interpreting Altman’s Score

Z > 2.99 is viewed as Going Concern

2.7 < Z < 2.9  possible insolvency

1.81 < Z < 2.7 increased probability of insolvency

Z < 1.8 very high probability

If Altman is converted to a credit rating then the following cutoffs are usually applied:

Altman Bond

Score  Rating

4          AAA

3.5       AA

2.9       A

2.5       BBB

2.25     BB

2          B

1.8       C

<1.8     D