Z - Sore of Altman

# Z - Sore of Altman - The Use of Credit Scoring Models and...

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The Use of Credit Scoring Models and the Importance of a Credit Culture Dr. Edward I. Altman Stern School of Business New York University

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Evolution of Scoring Systems Qualitative (Subjective) Univariate (Accounting/Market Measures) Multivariate (Accounting/Market Measures) Discriminant, Logit, Probit Models (Linear, Quadratic) Non-Linear Models (e.g. ., RPA, NN) Discriminant and Logit Models in Use Consumer Models - Fair Isaacs Z-Score (5) - Manufacturing ZETA Score (7) - Industrials Private Firm Models (eg. Risk Calc (Moody’s), Z” Score) EM Score (4) - Emerging Markets, Industrial Other - Bank Specialized Systems 2
Evolution of Scoring Systems (continued) Artificial Intelligence Systems Expert Systems Neural Networks (eg. Credit Model (S&P), CBI (Italy)) Option/Contingent Claims Models Risk of Ruin KMV Credit Monitor Model Blended Ratio/Market Value Models Moody’s Risk Cal Bond Score ( Credit Sights ) Z-Score ( Market Value Model ) 3

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Problems With Traditional Financial Ratio Analysis 1 Univariate Technique 1-at-a-time 2 No “Bottom Line” 3 Subjective Weightings 4 Ambiguous 5 Misleading 4
Forecasting Distress With Discriminant Analysis 5 Linear Form Z = a 1 x 1 + a 2 x 2 + a 3 x 3 + …… + a n x n Z = Discriminant Score (Z Score) a 1 a n = Discriminant Coefficients (Weights) x 1 x n = Discriminant Variables (e.g. Ratios) Example x x x x x x x x x x x x xx x x x x x x x x x x x x x x x x x x x x x x x x x EBIT TA EQUITY/DEBT

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“Z” Score Component Definitions Variable Definition Weighting Factor X 1 Working Capital 1.2 Total Assets X 2 Retained Earnings 1.4 Total Assets X 3 EBIT 3.3 Total Assets X 4 Market Value of Equity 0.6 Book Value of Total Liabilities X 5 Sales 1.0 Total Assets 6
Z Score Bankruptcy Model 7 Z = .012X 1 + .014X 2 + .033X 3 + .006X 4 + .999X 5 e.g. 20.0% Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + .6X 4 + .999X 5 e.g. 0.20 X 1 = Current Assets - Current Liabilities X 4 = Market Value of Equity Total Assets Total Liabilities X 2 = Retained Earnings X 5 = Sales ( = # of Times Total Assets Total Assets e.g. 2.0x) X 3 = Earnings Before Interest and Taxes Total Assets

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Zones of Discrimination: Original Z - Score Model Z > 2.99 - “Safe” Zone 1.8 < Z < 2.99 - “Grey” Zone Z < 1.80 - “Distress” Zone 8
Average Z-Score by S&P Bond Rating S&P 500: 1992 - 2001 Rating # Firms Average Z Score SD Average Z Score SD Average Z Score SD Average Z Score SD Average Z Score SD AAA 66 6.20 3.06 5.02 1.60 4.38 1.38 4.51 1.50 5.26 2.19 AA 194 4.73 2.36 4.30 1.91 4.05 1.83 4.03 1.89 4.23 2.09 A 519 3.74 2.29 3.61 2.26 3.47 2.01 3.61 2.18 3.92 3.26 BBB 530 2.81 1.48 2.78 1.49 2.70 1.58 2.84 1.74 2.60 1.54 BB 538 2.38 1.85 2.45 1.62 2.28 1.69 2.19 1.63 2.10 1.54 B 390 1.80 1.91 1.67 1.23 1.88 1.52 1.96 1.72 1.96 2.33 CCC+CC 9 0.33 1.16 1992 1996-2001 1995 1994 1993 9

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Estimating Probability of Default and Probability of Loss Given Defaults • Credit scores on new issues to estimate • Bond ratings equivalents on new issues and then, • Utilize mortality rates to estimate annual and cumulative defaults 10
Marginal and Cumulative Mortality Rate Equation MMR (t) = Total value of defaulting debt in year (t) total value of the population at the start of the year (t) MMR = Marginal Mortality Rate One can measure the cumulative mortality rate (CMR) over a specific

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Z - Sore of Altman - The Use of Credit Scoring Models and...

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