Altman z-score

As an investor a sound assessment of credit risk, the likelihood that your counterparty defaults, is very important. Both to determine whether the risk-return profile of a company still suites your preferences as well as to set your minimum required rate. One of the most commonly known methods used to quantify credit risk is the Altman z-score model.

Original Altman z-score model

The original Altman z-score model quantifies a default indicator z by taking a weighted sum of 5 different ratios as shown below. Originally it was used to measure the credit risk of publicly traded manufacturing companies.

z = 1.2 \cdot x_1 + 1.4 \cdot x_2 + 3.3 \cdot x_3 + 0.6 \cdot x_4 + 1.0 \cdot x_5

With

x_1 = \dfrac{working capital}{total assets}

x_2 = \dfrac{retained earnings}{total assets}

x_3 = \dfrac{EBIT}{total assets}

x_4 = \dfrac{market value of equity}{book value total}

x_5 = \dfrac{Revenue}{total assets}

Companies with higher z-scores are viewed as safer, lower z-score companies are riskier. Companies with a z-score larger than 2.99 are categorized as safe. Those with a score below 1.81 are categorized as very risky, meaning a high likelihood of bankruptcy. Those in between the 2 value are closely to monitor companies. Besides the z-score itself, tracking periodical changes in z-scores provides even more information on default risk.

Summary

Altman z-score model quantifies the credit risk of a certain company. The higher the score, the safer the company, thus the lower the credit risk.