An z score r edward altman is a leader in this area

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an Z-Score - r Edward Altman is a leader in this area, which sprung from his study on the use of -,--.,...,,,,1 ratios to predict corporate bankruptcy risk (Altman, E., "Financial Ratios, Discriminant _ - and the Prediction of Corporate Bankruptcy," Journal of Finance, September 1968). 'eloped a model for scoring a company based on various financial indicators and a way y that score (called Z-score) to assess a company's bankruptcy risk. To derive the model, used data from many bankrupt and non-bankrupt public companies along with a statisti- ~,_~~odology called Multiple Discriminant Analysis. Altman's weighted model to predict a vs Z-score follows: LOS Explain bankruptcy prediction models, and compute and interpret measures of bankruptcy risk. - Working caPital] [ [Retained EarningS] [ EBIT] [ Market Value of EqUity] [ Sales] 1.2 x + 1.4 x + 3.3 x + 0.6 x + 0.99 x ---- _ Total Assets Total Assets Total Assets Total Liabilities Total Assets -ariable in the Z-score model relates to financial strength. The first variable provides a of liquidity, while the second and third variables measure long-term and short-term -- .... ,.."hility.The fourth variable captures the company's levered status, while the fifth variable its total asset efficiency. y comparing Z-scores of bankrupt and non-bankrupt companies, Altman derived the follow- rpretations in Exhibit 4.7. ------ =X:-flBIT 4.7 Z-Scores and Their Interpretation Z-score Interpretation Z-score > 3.00 > Z-score > 1.80 > Z-score Company is healthy and there is low bankruptcy potential in the short term Gray area-company is exposed to some risk of bankruptcy; caution is advised Company is in financial distress and there is high bankruptcy potential in short term :ut-offs in this exhibit are shown to predict bankruptcy reasonably accurately up to two years -ance.The model is 95% accurate in the first year and 72% accurate in the second year. For beyond the second year, the model's predictive ability declines sharply. ication of Z-Score pute a Z-score for Home Depot, we use the financial statement information shown in Exhib- -_ and as reported (in millions) for the year ended January 30,2011, from Exhibits 4.1 and 4.3. - - =xtHIBIT 4.8 Financial Statement Information for Home Depot $13,479 10,122 $ 3,357 Shares outstanding, in millions . x Price per share . Market value of equity (MVE) . 1,623 $ 36.70 $59,564 assets . liabilities . capital (WC) . $40,125 $14,995 $ 5,839 Total liabilities (TL) . Sales . $21,236 $67,997 - assets (T A) . eamings (RE) . Depot's Z-score is computed as 4.464, which is detailed in Exhibit 4.9. Its 4.464 Z-score ~s the 3.00 lower cut-off for "safe" companies. Thus, we conclude that there is a low risk Home Depot going bankrupt in the short term.
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4-29 Module 4 I Credit Risk Analysis and Interpretation Z-Score Computation for Home Depot Financial Ratio Weight Score wCrrA ......... ............... •... , . REfTA . EBITrrA . MVErrL . SalesrrA . ($3,357/$40,125) x ($14,995/$40,125) x ($5,839/$40,125) x ($59,564/$21,236) x ($67,997/$40,125) x 1.2 1.4 3.3 0.6 0.99 0.100 0.523 0.480 1.683 1.678 Z-score = 4.464 Bankruptcy Prediction Errors Predictions are imperfect and errors occur. Two types of errors can arise from the Z-score model: Type I error (a false negative) and Type II error (a false positive). In Altman's Z-score model, a "positive" indicates bankruptcy. Thus, a Type I error occurs when a company's Z-score indicates the company is healthy, yet the company goes bankrupt. This can happen
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