Financial Health Ratings Are More Effective than Z ... - Rapid Ratings

Financial Health Rating (FHR) and Z‐Score Comparisons
Financial Health Ratings Are More Effective than Z‐Scores in Predicting Default
The Z‐score formula for predicting bankruptcy was developed in 1968 by Edward I. Altman, a financial
economist and professor at the Leonard N. Stern School of Business at New York University. The Z‐Score
was developed by utilizing a linear regression model in order to relate five financial statement ratios to
whether or not a firm filed for bankruptcy protection within two years. Still in use today, it is considered
one of the standard measures for detecting potential solvency problems in non‐financial public
corporations.
Rapid Ratings International has developed a unique proprietary process for rating the financial health of
a company called the FHR (for Financial Health Rating). FHRs are early indicators of companies'
improving and deteriorating financial positions and thus are ideally suited for use by risk managers who
are monitoring exposures. FHRs are more accurate measurements of corporate financial health and
future competitive sustainability than traditional tools, including market based tools, and therefore
translate into more accurate estimations of default probabilities.
Test Design: Rapid Ratings designed a test for the purpose of comparing the effectiveness of FHRs
versus Z‐Scores for providing advance indications of default events. The testing universe included
default events recorded since the end of 1998 through the end of 2008. For each company in the sample
set, we produced a quarterly time series of Z‐Scores. This test identified 258 companies for which Rapid
Ratings could obtain all the necessary data to calculate a series of Z‐Scores for the test period. We
compared the two measures, using >1.86 as an indication for default by the Z‐score, and less than 40 as
an indication of default for the FHR. Details of this analysis can be found in the appendix.
Test Results and Analysis: Using the criteria stated above, the Z‐Score indicated susceptibility to default
before the actual default date in 176 of the 258, or 68.2% of the companies tested. For these 176 cases,
the average “lead time” as defined by the number of months the Z‐Score‐signal‐associated date led the
actual default date was 23.6 months or almost two years.
In contrast, utilizing an FHR threshold of 40, the FHR time series had 211 cases, or 81.8%, categorized
as being susceptible to default. On lead time, the advantage as compared with Z‐score is even more
impressive. The average lead time for the date of the FHR signal was 36.0 months or approximately
three years.
Figure 1: Results Summary
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Model
Feature
Financial Health Rating (FHR) and Z‐Score Comparisons
Conclusion: Although various versions of Z‐Score‐type models are still in use today, the effectiveness of
each one is constrained by its inherent limitations. The FHR employs a vastly larger input data set for
calibration, a more robust and pertinent dependent variable, and global industry‐specific models.
Moreover, because FHRs offer significant differentiation between different levels of risk, they are
superior metrics for managing, measuring, and budgeting for financial health risks beyond merely giving
indications of susceptibility to bankruptcy. This is evidenced by the FHR system outperforming the
Z‐Score in terms of accuracy by a identifying 20% more of the cases as well as providing warning signals
about 50% earlier on the average. Both the accuracy and timing tests indicate that Rapid Ratings
provides a significant comparative advantage to lenders, investors and risk managers.
Figure 1: Features Matrix
Z‐Score Model Rapid Ratings International’s FHR Model
Model type Multivariate discriminant analysis
(linear regression model).
Original model
foundations
Foundation model was based on 66
companies in the US manufacturing
sector, half of which had filed for
bankruptcy. Small firms with assets of
less than $1 million were eliminated.
Model inputs 5 FINANCIAL RATIOS
Altman started with 22 financial ratios
but reduced the number to five which
offered the best results:
• Working Capital/Total Assets
• Retained Earnings/ Total Assets
• EBIT /Total Assets
• Market Value of Equity/Total Liabilities
• Sales/Total Assets
Model Outputs Forecasts the relative likelihood of a company
entering bankruptcy within a 2 year period.
Differentiability Tests have shown significant differences between
three groupings or clusters of Z‐Scores, but not a
one‐to‐one relationship with bankruptcy between
a Z‐Score of 2.0 and a Z‐Score of 2.2.
Global
benchmarking
Multivariate Econometric Panel Data Model (non‐linear and adaptive
modeling).
Foundation model was based on 9 million observations drawn from over
300,000 companies from more than 30 years from more than a dozen
countries. The database contained a large number of small, medium and
large scale companies. These companies were both listed and unlisted.
62 FINANCIAL RATIOS
OPERATING PERFORMANCE
Cost Structure (e.g. COGS/tot. exp.; taxes/revenues)
Profitability (e.g. NPAT/assets; EBIT/capital employed)
Sales Efficiency (e.g. sales/inventories; sales/working capital)
FINANCIAL POSITIONING
Debt Service (e.g. EBIT/interest exp.; interest exp./total liabilities)
Leverage (e.g. total liabilities/sales; total liabilities/total assets)
Working capital efficiency (e.g. working cap./total revenue; term
liabilities/cap. employed)
Assesses the financial health of each company against a very rich global
benchmarking system.
Tests have reflected significant evidence of a one‐to‐one relationship
between FHR level and subsequent incidence of default.
Not employed. This is a fundamental feature of the Rapid Ratings system that
ensures much more accurate financial performance measurement.
Industry focus Not designed for individual industries Focus on 24 separate industries permits greater precision of risk
measurement and significantly greater forecasting accuracy.
Effectiveness in
providing early
warning signals
Tests by Eidleman demonstrate greater
than 70% reliability in differentiating
companies that go bankrupt within two
years and those that do not.
Test show that 80% of companies that suffer s default event within the
next 12 – 24 months are in the Rapid Ratings Red Zone of susceptibility to
default defined by an FHR of less than 40.
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