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The Z-score, developed by Professor Edward Altman in 1968, is a financial metric designed to measure the likelihood of a company facing bankruptcy. Altman introduced the Z-score as a statistical model combining various financial ratios to assess a company’s financial health. The score serves as a predictive tool, helping analysts and investors gauge the credit risk associated with a business. A higher Z-score generally indicates financial stability, while a lower score signals potential distress, making it a valuable resource for mapping financial performance to credit profile.

Credit risk measures the likelihood of the borrower defaulting on its obligations. A higher credit risk generally corresponds to a lower credit rating for the borrower, leading to higher interest rates to compensate for the increased default probability. Conversely, entities with lower credit risk and higher credit ratings benefit from lower interest rates. Credit risk assessments are often based on financial metrics such as Z-scores and other financial analyses that evaluate the borrower’s financial health.

The Z-score is closely correlated with credit risk as it provides a quantifiable measure of a company’s financial stability and likelihood of default. Developed by Edward Altman, the Z-score combines key financial ratios to produce a single value that indicates the financial health of a company. A higher Z-score reflects stronger financial stability and lower credit risk, suggesting the company is less likely to default on its obligations. Conversely, a lower Z-score signals financial distress and higher credit risk, indicating a greater probability of default. This correlation makes the Z-score a useful tool for credit risk assessment, as it can be mapped to credit ratings commonly used by financial institutions. In transfer pricing, Z-scores can help establish arm’s length interest rates for intercompany transactions by aligning pricing with the borrower’s credit risk profile.

The Z-score is calculated using a formula developed by Edward Altman that combines key financial ratios to assess a company's financial health and likelihood of default. The formula varies slightly depending on whether it is applied to public companies, private companies, or non-manufacturing firms. For publicly traded manufacturing companies, the original Z-score formula is:


Z=1.2X1+1.4X2+3.3X3+0.6X4+1.0X5 , Where

X1 = Working Capital / Total Assets

X2​ = Retained Earnings / Total Assets

X3​ = Earnings Before Interest and Taxes (EBIT) / Total Assets

X4​ = Market Value of Equity / Total Liabilities

X5​ = Sales / Total Assets

Each component reflects a different aspect of financial performance, such as liquidity, profitability, leverage, and asset efficiency. The coefficients (weights) assigned to each ratio were determined by Altman based on statistical analysis to optimize predictive accuracy. The resulting Z-score is then interpreted, with higher scores indicating lower bankruptcy risk and better financial health. Variations of the formula exist for private companies and non-manufacturing firms to account for differences in financial structures.