The Analysis of Credit

Risk and Return

LINKS

Link to previous chapter

Chapter 19 showed how the

analysis of fundamental s
helps in the evaluation of
equity risk. Value-at-risk
profiles were developed
to aid active investing.

)
This chapter

This chapter shows how

fundamental analysis helps
in the evaluation of the risk
of a firm defaulting on its
debt. Value-at-risk profi les
Do the
financial
statements give
I How are credit
rating scores
developed?
How are
value-at-ri sk
profiles
How does pro
form a analysis
aid in the
are developed to assess indications of developed for evaluation of
default risk. whether a firm business debt? credit risk,
might default liquidity
on its debt? planning, and
What measures financial
are re levant? strategy?
Link to Web page

To learn more about

risk, visit the text's
Web site at
www.mhhe.com/penmanSe.
Most of the analysis in the book to this point has been concerned with the valuation of the
firm and the valuation of the equity claim on the firm. This chapter deals with the other
major claim on the firm, the debt. Thus far we have accepted the market value of debt as
its value. But buyers and sellers of debt need to know how to establish the market value
of debt.
In most debt contracts, the payoffs to debt are specified in the contract. So Step 3 of
fundamental analysis- forecasting payoffs-is trivial. But forecasted payoffs have to be
discounted (in Step 4) to get a valuation. Discounting requires a measure of the required
return for debt, and this required return, like that for equity, depends on the riskiness of
the debt: The required return for debt is the risk-free rate for the term of the debt plus a
default premium that varies with default risk. Default risk, or credit risk, is the risk of
 Chapter 20 The Analysis of Credit Risk and Return 681

After reading this chapter you should understand: After reading th is chapter you should be able to:

• How default risk determines the price of credit and the
cost of debt capital for the firm.
• What determines default risk .
• How default risk is analyzed .
• What bond rating agencies do.
• How credit scoring models work.
• The difference between Type I and Type II errors in
predicting default.
• How pro forma ana lysis identifies default scenarios.
• How value-at-risk analysis is incorporated into default
analysis.
• How financial strategy works.
• Reformulate and annotate financial statements in
preparation for credit analysis.
• Calculate liquid ity, solvency, and operational ratios
that are pertinent to credit ana lysis.
• Calculate credit scores using financial ratios.
• Calculate a probability of bankruptcy using financial
ratios.
• Tra de off Type I and Type II default forecasting errors.
• Prepare pro formas for default scenarios .
• Prepare value-at-risk profiles for debt.
• Forecast default points.
• Prepare a default strategy.

default; that is, the risk of not receiving timely interest and return of principal as specified
in the debt agreement. This chapter brings fundamental analysis to the task of evaluating
default risk.
Analysts talk of the required return for debt. But debt taken on by the firm is also credit
supplied by those who purchase the debt. Accordingly, we can talk of the required return for
debt as also being the price of credit. Whatever the terminology, the amount charged by
suppliers of credit is the cost of debt for the firm.

THE SUPPLIERS OF CREDIT

Suppliers of credit to the firm include the following:
• Public debt market investors, who include (long-term) bondholders and (short-term)
commercial paper holders. Sometimes public debt is packaged by banks into bundles of
securitized debt obligations or collateralized debt obligations, which are then traded as a
package at a price that reflects the underlying credit ri sk. In turn, credit default swaps,
which insure the debtholder against default, are also priced on the perceived credit
risk. At all points in thi s chain, keeping track of the underlying risk is important (a poi nt
that was not always understood in the securitizations prior to the global financial crisis).
Often, publicly traded debt is unsecured, that is, not collateralized by specific assets.
Bondholders are protected by bond covenants, which restrict the firm from specified
actions that might increase default risk, and violation of a bond covenant is technically a
default. To evaluate default risk, investors in this type of debt rely on those corporate
disclosures about the overall health of the firm that are required by the Securities and
Exchange Commission (SEC) in the United States for all publicly traded securities. They
also rely on bond ratings, which are published by rating agencies to indicate default risk.
Accordingly, it is the rating agencies that are particularly concerned with the analysis of
risk, and they develop rating models that involve the analysis of fundamentals.
682 Part Five The Analysis of Risk and Return

• Commercial banks, which make loans to firn1s. They are usually closer to a firm's
business than a bondholder, so they have access to more information regarding default
risk. The loan officer serves as the credit analyst, and loan officers, like bond rating
agencies, have models that aid in credit scoring. Their credit scoring methods are tied
into their bank's internal risk management, to protect the bank and to satisfy regulatory
constraints on its exposure to risk. Banks originate loans on the basis of credit scores.
They then use credit scoring to measure the quality of loans that they sell to other
institutions and to monitor the default risk ofloans they retain.
• Other fina ncial institutions, such as insurance companies, finance houses, and leasing
firms , make loans, much like banks, but usually with specific assets serving as
collateral. They also arrange specialty financing such as leases of long-term assets.
• Suppliers to the firm, who grant (usually short-term) credit upon delivery of goods and
services. The credit can be granted with or without explicit interest.
Each supplier of credit has a price for granting credit- the required return- and each
needs to analyze the risk of default and charge accordingly. Bondholders charge a yield to
maturity based on their risk assessment and set bond prices accordingly. Banks charge an in-
terest rate over a base rate (the prime rate for their safest customers) that depends on default
risk. And suppliers charge a higher price for goods and services ifthe default risk is high. If
risk is deemed to be unacceptable, no price is acceptable to the lender, so credit is denied.
The explicit price is only one dimension of the price. Just as a supplier might charge no ex-
plicit interest for credit but charge a higher price for goods supplied to compensate, a bond-
holder will charge a lower yield if bond covenants have more protection, a finance firm will
charge less with collateral, and a bank will charge less for loans with personal or parent com-
pany guarantees. Such restrictions increase the (implicit) cost of capital to the borrowing firm .

FINANCIAL STATEMENT ANALYSIS FOR CREDIT EVALUATION

Equity analysis calls for a particular ratio analysis (of profitability and growth), which
was laid out in Chapters 12 and 13. Credit analysis calls for a different analysis, and many of
the ratios involved are different from those for equity analysis. As with equity analysis, the
emphasis is on forecasting. Rather than identifying those ratios that forecast profitability and
growth, credit analysis identifies ratios that indicate the likelihood of default. Therefore, it is
also referred to as default analysis. As with equity analysis, the credit analyst identifies
ratios from financial statements that have first been reformulated for the purpose.

Reformulated Financial Statements

For the equity analysis financial statements were reformulated to uncover what is most impor-
tant to equity investors, core operating profitability. For credit analysis, the statements must
be in a form to uncover what is most important to creditors, the ability to repay the debt.
Reformulation, as before, involves reclassifying items in the financial statements and
bringing more dollar detail into the financial statements from the footnotes. In addition, the
discovery process leads to some annotation of the statements. Annotation involves summa-
rizing features of the financing that cannot be expressed as dollar amounts on the balance
sheet but which are pertinent to the risk of default.

Balance Sheet Reformulation and Annotation

The ability to repay amounts to having cash at maturity. Maturities differ, but it is standard
practice to distinguish debt as short-term (usually thought of as maturing within one year)
and long-term (maturing in more than one year). Published balance sheets are usually
prepared with a division into current and noncurrent (long-term) assets and liabilities, so
 Chapter 20 Th e A nalysis of Credit Risk and Return 683

the balance sheet needs little reformulation. Indeed, it is because balance sheets are
structured with the creditor in mind that we had to reformulate them for equity analysis. For
credit analysis, there is no need to distinguish operating debt from financing debt. Both are
claims that have to be paid.
Some reformulation and annotation is called for, however. Here are points to consider:
• Details on different classes of debt and their varying maturities are available in the debt
footnotes ; these details can be inserted in the body of reformulated statements.
• Debt of unconsolidated subsidiaries (where the parent owns less than 50 percent but has
effective control) should be recognized. For example, oil companies sometimes raise
cash through joint ventures in which they hold less than 50 percent interest, and they
cover the debt of the joint venture if revenues in the venture are insufficient to service its
debt. The Coca-Cola Company owns less than 50 percent of some of its bottling com-
panies but effectively borrows through these subsidiaries. The debt of these subsidiaries
or joint ventures should be included in a consolidated reformulated statement, on a pro-
portional basis, ifthe parent company is ultimately responsible for it.
• Long-term marketable securities are sometimes available for sale in the short term if a
need for cash arises. For analyzing short-term liquidity, therefore, reclassify them as a
short-term asset.
• Remove deferred tax liabilities that are unlikely to revert from liabilities to shareholders'
equity. Such deferred taxes, created by a reduction of earnings and equity, are liabilities
that are unlikely to be paid. So classify them back to equity.
• Add the LIFO reserve to inventory and to shareholders' equity to convert LIFO inventory
to a FIFO basis. FIFO inventory is closer to current cost, so it is a better indicator of cash
that can be generated from inventory.
• Off-balance-sheet debt can be recognized on the face of the statement. See Box 20.1.
• Contingent liabilities that can be estimated should be included in the reformulated
statements. Contingent liabilities that cannot be estimated should be noted as part of
the annotation. Contingent liabilities include liabilities under product, labor, and
environmental litigation. In the United States, GAAP requires these li abilities to be put
on the balance sheet if the liability is "probable" and the amount of the loss can be
"reasonably estimated." Footnote disclosure is otherwise required, unless the possibility
of loss is " remote." Inspect the contingent liabilities footnote.
• The ri sk in derivatives and other financial instruments should be noted. Inspect the
financial instruments footnote .
Reformulated Income Statements
The analyst reviews the income statement to assess the abi lity of the firm to generate
operating income to cover net interest payments. Thus the reformulated income statement
that distinguishes after-tax operating income from after-tax net financial expense serves
debt analysis well. So does the di stinction in reformulated statements between core and
unusual items for, with a view to future default, the issue is whether future core income will
cover future core financial expense.
Reformulated Cash Flow Statements
The reformulated cash flow statement prepared for equity analysis also serves debt analysis.
In particular, the reformulation of GAAP cash flow from operations to exclude after-tax net
interest identifies (unlevered) cash flow from operations that is available to pay after-tax
interest. And the reclassification of investments in financial assets (which GAAP places in
the investing section) as financing flows rather than investment flows yields a number for
investing cash flows that has integrity, and captures net amounts of bond issuing activity.
Off-balance-sheet financing transactions are arrangements to
finance assets and create obligations that do not appear on the
balance sheet. Some types of off-balance-sheet financing are:
• Operating leases. Leases that are in substance purchases,
cal led capital leases, appear on the balance sheet, with
the leased asset as part of property, plant, and equipment
and the lease obligation as part of liabilities. Leases that are
not in substance a purchase, called operating leases, do not
appear on the balance sheet; they are summarized in foot-
notes. However, lessees and lessors have been creative in
writing lease agreements to get around the letter of the rules
for capitalizing leases. Exam ine operating leases in the foot-
notes and assess whether these are effectively an obligation
to use an asset for most of its useful life. If so, bring them
onto the balance sheet as a capita l lease. The lease amount
is the present va lue of the payments under the lease .
• Agreements and commitments can create obligations that
should be recognized :
Third-party agreements: A third party purchases an asset
for the firm and the firm agrees to service the third party's
debt on the purchase.
Throughput agreements: A firm agrees to pay for the use
of the faci lities of another firm .
Take-or-pay agreements: A firm agrees to pay for goods in
the future, regardless of whether it takes delivery.
Repurchase agreements: A firm sells inventory but agrees
to repu rchase the inventory at selling price or guarantees a
resale price to the customer. Agreements to sell and repur-
chase debt ( " repos") are similar. Prior to its bankruptcy,
Lehman Brot h ers was accused of moving debt off its bal-
ance sheet vi a repos.
• Sales of recei v ables w ith recourse. A firm sells its receivables
for cash, removing them from the balance sheet, but has an
obligation to i ndemnify the holder of the receivables.
• Unfunded pension liabil ities. In some countries (but not
the United States) significant pension liabilities may not
be on the ba I ance sheet.
• Guarantees o f third-party or related-party debt. Watch
for gua rantees of the debt of nonconsolidated subsidiaries
by a parent company.
• Special-purpose entities, off-balance-sheet partnerships,
and structured finance vehicles. Firms can create entities in
w hich others have control (so they are not consolidated),
to accomplished specific purposes-like the securitization
of assets or acquiring assets with off-balance-sheet leases
("synthetic leases") . Although the fi rm does not have
control, it might retain residual risk if these entities run into
financial diffi c ulties. Th e obligations may be in the form of
recourse liabi l ities or put options on the firm 's own stock.
The Enron affair highlighted the danger of these special-
purpose entities, as did banks' holdings of securitized debt
and mortgages in special investment vehicles (SIVs) during
the credit crisis of 2008 .

With reformulated financial statements in hand, the ratio analysis can begin. With the
two types of maturities in mind- short-term and long-term- ratio analysis groups ratios
into two types, short-term liquidity ratios and long-term solvency ratios. Both sets of ratios
are indicators of the ability to repay, but at different maturity dates. The ratio analysis is
completed with some of the operational ratios that we have already covered.
All three sets of ratios are benchmarked with comparisons to similar firms and with
trend analysis over time. The credit analyst looks fo r deteriorations in the ratios over time
and relative to comparison firms .

Short-Term Liquidity Ratios

Short-term creditors-suppliers, short-term paper holders, and long-term lenders of debt
that is shortly to mature, for example- are concerned with the firm's ability to have enough
cash to repay in the near future. The long-term lender is also interested in short-term
liquidity because if the firm cannot survive the short term, there is no long term.
Working capital is current assets minus current liabilities. As current assets are those
expected to generate cash within one year and current liabilities are obligations due to mature
within one year, working capital and its components are the focus ofliquidity analysis.
The typical balance sheet has five types of current assets:
1. Cash and cash equivalents
2. Short-term investments

684
 Chapter 20 The Analysis of Credit Risk and Return 685

3. Receivables
4. Prepaid expenses
5. Inventories
Each item has an expected date for realization into cash. Inventories typically have the
longest time to cash as they first have to be sold and converted into a receivable, and then
the receivable has to be turned into cash. Short-term investments (to which readily mar-
ketable long-term securities can be added in the balance sheet reformulation) may be closer
to cash than receivables or prepaid expenses, depending on the maturity of the investments.
Under historical cost accounting, the carrying amount for inventories usually understates
their cash value, although the lower-of-cost-or-market rule for inventories can give them a
market valuation when the firm is in distress .
Three types of current liabilities appear on the typical balance sheet:
I. Trade payables
2. Short-term debt
3. Accrued liabilities
All three are typically close to their cash value.
The balance sheet is a statement of stocks, so it gives the stocks (amounts) of net liquid
assets at a point in time. Liquidity flows are in the cash flow statement. Liquidity ratios
involve both the balance sheet stocks of cash and near-cash items and flows of cash in the
cash flow statement.

Liquidity Stock Measures

CutTent assets
Current ratio = - - - - - - -
Current liabilities
. k( .d ) . Cash+ Short-term investments+ Receivables
Qmc or ac1 test rat10 = - - - - - - - - - - - - - - - - - -
Current liabilities
. Cash+ Short-te1111 investments
C as h rat10 = - - - - - - - - - - - -
CmTent liabilities

These measures indicate the ability of near-cash assets to pay off the current liabilities. The
numerators of these ratios indicate different cash maturities. So, for example, the quick
ratio includes only quick assets in the numerator by excluding inventories that may take
some time to turn into cash (and whose carrying values are not usually their cash values).
The cash ratio involves only assets with almost immediate liquidity.

Liquidity Flow Measures

. Cash flow from operations
C as 11 fl ow r a t i o = - - - - - - - - - -
Current liabilities
. . Cash+ Short-te1m investments+ Receivables
Defensive mterva1 = x 365
Capital expenditures
Cash flow to Cash flow from operations
capital expenditures Capital expenditures

The first measure indicates how well the cash flow from operations covers the cash needed
to settle liabilities in the short term. The second ratio measures the liquidity available to meet
capital expenditures without further borrowing. Multiplying by 365 yields the number of
686 Part Five The Analysis of Risk and Return

days expenditures can be maintained out of near-cash resources. The third measure is free
cash flow in ratio form and indicates to what extent capital expenditures can be financed out
of cash from operations. Sometimes forecasted expenditures are used in the denominators of
the second and third measures.

Long-Term Solvency Ratios

Long-term debtholders watch the firm 's immediate liquidity, but they are primarily
concerned with its ability to meet its obligations in the more distant future. Focus therefore
moves to incorporate the noncurrent sections of the balance sheet in ratios.

Solvency Stock Measures

Total debt (Current+ Long-term)

Debt to total assets = -------'------~--­
Total assets (Liabilities + Total equity)
. Total debt
Debt to eqmty = - -- - -
Total equity
. Long-term debt
Long-te1m debt ratio = - - -- - - - -- - - -
Long-te1m debt+ Total equity

The first two ratios capture all debt, the third just long-term debt. The first two differ in the
denominator but capture similar characteristics. Net debt can be used in the numerator
when financial assets are available to pay off the debt (in thi s case the denominators of the
first and third ratios are reduced by financial assets).

Solvency Flow Measures

Interest coverage Operating income
(times interest earned) Net interest expense

. ) Unlevered cash flow from operations

Interest coverage (cash b as1 s = ----------~~--
Net cash interest
Operating income + Fixed charges
Fixed-charge coverage = - - - - - - - - - - - --
Fixed charges

Fixed-charge coverage Unlevered cash flow from operations + Fixed charges

(cash basis) Fixed charges

Unlevered cash flow from operations

CF 0 to debt = ----------~---
Total debt

These ratios are improved (as indicators of the future) by measuring operating income
and net interest as core income and expense. The two interest coverage ratios give the number
of times operating earnings and cash flow from operations, respectively, cover the interest
requirement. The numerators and denominators are from the reformulated income and cash
flow statements. Some definitions consider only interest expense, in which case the numera-
tor includes interest income and the denominator excludes it. Fixed charges are interest and
principal repayments (including those on leases) and preferred dividends, so fixed-charge
coverage measures the number of times total debt service is covered. The last ratio measures
cash flow relative to total debt repayments to be made, not just the current repayment.
 Chapter 20 Th e Anal)'Sis of Credit Risi< and Return 687

These ratios give not only an indication of solvency but also an indication of a firm 's
debt capacity. Low coverage ratios suggest that a firm has capacity to assume more debt
(all else being equal).

Operating Ratios
The ratios just listed pertain directly to liquidity and solvency. But liquidity and solvency
are driven in large part by the outcome of operations, so operating ratios are also indicators
of debt risk . It is sometimes the case that a firm can be quite profitable in operations and
still have short-term liquidity difficulties, but both short-term liquidity and long-term
solvency problems are far more likely to be induced by poor operating profitability.
Interest coverage, for example, is just a restatement of the FLEV x SPREAD, and so is
driven by financial leverage (FLEV) and the operating spread (SPREAD), that is, the re-
turn on net operating assets relative to net borrowing costs. And these measures, in turn ,
are driven by lower-order d1ivers. Thus to complete the ratio analysis, analyze profitability
and changes in profitability along the lines of earlier parts of the book. And watch for the
"red flag" indicators (in Chapter 16) that indicate deterioration. If receivables or inventory
turnover increases, for example, liquidity problems could result.

FORECASTING AND CREDIT ANALYSIS

Liquidity, solvency, and operational ratios reveal the current state of the firm. But the credit
analyst is concerned with default in the future. Do the ratios predict default? Some of them
might be symptoms of financial distress rather than predictors. Discovering that interest
coverage is low is important to the analyst. But anticipation of a low interest coverage
ahead of time is also important. And so for all ratios. Indeed, once liquidity and coverages
have deteriorated, it might be too late.
The analyst thus turns to forecasting. His aim is to produce a credit score that indicates
the probability of default.

Prelude to Forecasting: The Interpretive Background

Before forecasting, the analyst must have a good understanding of the conditions under
which credit is given to the firm . Such an understanding provides the information necessary
for forecasting. It enables the analyst to bring her judgment to supplement quantitative
techniques. And it provides perspective to interpret ratios and other financial data. A par-
ticular ratio- a current ratio of less than 1.0, for example- might be seen as inadequate for
a firm with large inventories and receivables but quite adequate for a firm with no invento-
ries or receivables.
The analyst needs to understand the following points and include salient ones in the
annotations to the reformulated statements:
• Know the business. Just as the equity analyst must know the business before attempting
to value the equity, so must the credit analyst. Understand the business strategy and
understand the drivers of value in the strategy. And understand the risks that the strategy
exposes the firm to.
• Appreciate the "moral hazard" problem of debt. The interest of debtholders is not the
prime consideration for management. Members of management serve the shareholders
(and themselves), not the debtholders. So they can take actions that benefit the
shareholders at the expense of debtholders. They can borrow to pay a large dividend to
shareholders. They can pursue highly risky strategies with high upside potential and
use debt to leverage the upside payoff. If the strategy is successful, shareholders benefit
688 Part Five Th e Analysis of Risk and Return

enormously, but debtholders just get their fixed return . If they fail , debtholders (and
shareholders) can lose all.
• Understand the financing strategy. Does the firm have a target leverage ratio? What is
the firm 's target payout ratio? What sources of financing will the firm rely on? Does the
firm hedge interest rate risk? If borrowing across borders, does it hedge currency risk?
• Understand the current financing arrangements . What are the firm 's banking relation-
ships? Does it have open lines of credit? When might they expire? What is the current
composition of the firm's debt? What debt is secured? What debt has seniority? What are
the maturity dates for the debt? What are the restrictions on the firm in its debt
agreements?
• Understand the quality of the firm's accounting.
• Understand the auditor's opinion, particularly any qualifications to the opinion.

With this background, the analyst develops forecasts. We cover two forecasting tools
here. The first develops credit scores based on predictions from financial ratios. The second
brings the pro forma profitability analysis and value-at-risk analysis of earlier chapters to
the task of credit analysis.

Ratio Analysis and Credit-Scoring

Figure 20. l depicts the deterioration of a number of ratios over five years prior to
bankruptcy (failure). The graphs are from one of the original stud ies on bankruptcy
prediction by William Beaver in the 1960s, but they apply much the same today. Average
ratios for bankrupt firms are compared with those of comparable firms that did not go
bankrupt. The ratios for firms going bankrupt are of lower quality than those for nonbank-
rupt firms , even five years before bankruptcy. And they become significantly worse as
bankruptcy approaches. So, benchmarking ratios against those for comparable firms,
combined with a trend analysis, does give an indication of future bankruptcy.
Two issues arise in getting default predictions from accounting ratios:

1. Many ratios must be considered, and the analyst needs to summarize the information
they provide as a whole. A low interest coverage but a high current ratio may have
different implications than a low interest coverage and a low current ratio. A composite
credit score needs to be developed.
A bond rating of the sort published by Standard & Poor's and Moody 's is a compos-
ite score. Standard & Poor's ratings range from AAA (for firms with highest capacity to
repay interest and principal) through AA, A, BBB, BB, B, CCC, CC, C to D (for firms
actually in default). The ability to repay debt rated BB and below is deemed to have
significant uncertainty. Moody's rankings are similar: Aaa, Aa, and A for high-grade
debt, then Baa, Ba, B, Caa, Ca, C, and D. These debt ratings are published as an
indicator of the required bond yield, and indeed the ratings are highly correlated with
yields.
A bank typically summarizes information abo ut the creditworthiness of a firm in a
credit score. This score can be in the form ofa number ranging from one to seven or one
to nine, or qualitative categories such as "normal acceptable risk," "doubtful," and
"nonperforming.''
2. Errors in predicting default and the cost of prediction errors have to be considered. The
financial ratios of fai ling and non failing firms are different on average but some fai ling
firms can have ratios that are similar to those of healthy firms. A firm going bankrupt
could have the same current ratio and interest coverage ratio as one that wi ll survive .
 Chapter 20 The Anal)'sis of Credit Risk and Return 689

FIGURE 20.1 The Behavior of Selected Financial Statement Ratios over Five Years Prior
to Bankruptcy, for Firms That Failed and Comparable Firms That Did not Fail.
Ratios for failed firms (on the dotted line) are of lower quality than those for nonfailed firms (on
the solid line), and they deteriorate as bankruptcy approaches.
Cash flow Net income Total debt
Total debt Total assets Total assets
+As.____ +. I .79 \
I
I
+.3S .78 I
I
I

+.2S .0
. / .6S
I

\
-·
/
\

.
/

+. lS /
/ ' .S8 \
\

'- - - _.. ._ .....

/ / \
/
I
- .1
+.OS
''
" I
I .S I
/
/ ' I
I

- .OS I .44
?' I
I
' I
' -.2
-.lS ' I
.37
''

2 3 4 s 2 3 4 s 2 3 4 s
Year before failure Year before fa ilure Year before failure

Total assets
Working capital C urrent (in millions of dollars)
Total assets ratio

.42 3.S 8

.36

.30 3.0
'
---- ·--- ·
.24 '' 7
/ '
I 2.S
.18 / '\
I
I
I

/
~ --
..
_ --- -- -
I
/ ',,
\
I
. 12 I
/
/ •,
I / '
I
' ''
.06 I 2.0 6 '>,

' '>

2 3 4 s 2 3 4 s 2 3 4 s
Year before failure Year before fai lure Year before fai lure

- - Nonfailed firms - - - - Failed firms

Source: W. H. Beaver, •lfinancial Ratios as Predictors of Failure," Journal ofAccou111i11g Research. Supplement, 1966, p. 82.

A bank loan officer might then classify both firms as low default risk, approve loans to
both, and generate loan losses for the bank (from the bankrupt firm) . Alternatively she
might classify them both as having high default risk and deny credit, losing good
business for the bank (from the nonbankrupt firm).
The first issue calls for a method of combining ratios into one composite score that
indicates the overall creditworthiness of the firm. The second issue calls for a method of
trading off the two types of errors that can be made. We deal with each in turn.
690 Part Five The Analys is of Risk and Return

Credit Scoring Models

Credit scoring models combine a set of ratios that pertain to default into a credit score . A
credit sco ring model has the fo rm

Credit score = (w 1 x Ratio1) + (w2 x Ratio2) + (w 3 x Ratio 3) + · · · + (wN x RatioN)

That is, the model sums ratios that are weighte d by weights w. A variety of statistical
techniques can be used to determine the weights, but two common ones are multiple
discriminant analysis and logit analysis.

Multiple Discriminant Analysis. Z-score ana lysis, pioneered by Edward Altman, 1

utilizes discriminant analysis techniques. The model has been refined over time but the
original model , developed in the 1960s, took the form

Z-score = 1_2 ( Working capital)+ 1 .4(Retained earnings)

Total assets Total assets

+ 3 _3 ( Earnings before interest and taxes)

. Total assets

+ 0 _6 ( Market value of equity ) + 1.o( Sales )

Book value ofliabilities Total assets

To identify predictors in a model like this, select a sample of firms that went bankrupt in the
past and a random sample of firms that did not. Calculate a full set of liquidity, so lvency,
and operational ratios for these firms. Discriminant analysis, applied to the hi storical data,
then selects those ratios that jointly best discriminate between firms that subsequently went
bankrupt and those that did not, and then calculates coefficients on the selected ratios that
weight them into a Z-score. The weights are calculated to minimize the differences in
Z-scores within bankrupt or nonbankrupt groups but to maximize the differences in scores
between the two groups. The Z-score indicates the relative likelihood of a firm not going
bankrupt, so a firm with a high score is less like ly, a firm with a low score is more likely,
and those with intermediate level scores are in a gray area.
The Z-score model is based on firm s going bankrupt, but models also can be estimated
with default on debt or other conditions of financi al distress as the defining event. And the
model can be adapted to situations having more than two outcomes. So a model of bond
ratings (with several classes) also can be built. Other ratios, such as asset size, interest
coverage, the current ratio, and the variability of earnings, have appeared in similar
published model s.

LogitAnalysis. Logit analysis is based on different statistical assumptions from di scriminant

analysis and delivers a score between zero and 1 that indicates the probability of default.

1 E. Altman, " Financial Ratios, Discriminant Analysis, and t he Prediction of Corporate Bankruptcy,"

Journal of Finance, Septem ber 1968, pp. 589- 609.