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FRM Part II · FRM Exam Part II · Estimating Default Probabilities

A credit analyst at a bank uses the original Altman Z-score model for publicly traded manufacturing firms. Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5. Which ratio is used as X3 in this model?

X3 in the original Altman Z-score is EBIT divided by total assets, a measure of operating profitability. Retained earnings to assets is X2, market equity to liabilities is X4, and sales to assets is X5, so only EBIT over total assets matches X3.

  1. ARetained earnings divided by total assets
  2. BMarket value of equity divided by book value of total liabilities
  3. CEBIT divided by total assetsCorrect
  4. DSales divided by total assets

Explanation

In the original Altman model, X1 is working capital/total assets, X2 is retained earnings/total assets, X3 is EBIT/total assets, X4 is market value of equity/book value of total liabilities, and X5 is sales/total assets. The retained earnings ratio is X2, not X3.

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