Estimating Private Company Default Risk with Altman Z-Scores

Summary

The document outlines a proposed approach to estimating default risk for private companies using seven years of financial data from about 3,000 firms. It gives the private-company Altman Z′ formula and lists its five accounting inputs: working capital, retained earnings, EBIT, book equity relative to debt, and sales, each scaled by assets except the equity-to-debt ratio.

The author plans to compare the resulting Z′ values with an internal credit scale of four grades, then estimate default probabilities. The document asks whether this mapping is sound and considers a normal distribution or a Black-Scholes-Merton approach, but it supplies no answer, calibration procedure, or empirical results. A score mapping alone does not establish default probabilities; estimation would require observed defaults over a defined horizon and validation on suitable data. The proposed formula and its suitability for the particular companies are not evaluated here.

Key ideas

• The proposed analysis applies the private-company Altman Z′ formula to company financial statements.
• The formula combines five accounting ratios, including profitability, leverage, liquidity, and asset turnover measures.
• The author intends to map Z′ values to an internal four-grade credit scale.
• The document raises probability calibration as an open question and does not provide a method or results.

Tags

# credit risk - How to calculate the probability of default (private companies)?


# credit risk - How to calculate the probability of default (private companies)?












Part of my master thesis I am working with a company. I have the project to use their financial database with all the financials data (7 years) of approximately 3’000 companies.

They have their own credit score from 1 that is the best score, to 4 the worst. What I intend to do is to calculate the Z-score (Altman score) and do a corresponding map between these two scores.

My ultimate goal is to compute the probability of default for these two different credit score.

Could you advise me if my logic of how to do it is correct? Or I am free to take any advises with a different approach. For instance I am hesitating to use the Black-Schole-Merton model to have the probability of default.

My first step is: calculate the Z-score of each company with this formula:

Formula for Private Companies: (Altman 2000) : Z' = 0.717*X1 + 0.847*X2 + 3.107*X3+ 0.420*X4+0.998*X5

X1=Working Capital/Total Asset

X2=Retained Earnings / Total Assets

X3=Earnings Before Interest and Taxes / Tot Assets

X4=Book Value of Equity / Book Value of Total Debt

X5=Sales / Total Assets

2nd step: I would like to do a corresponding table between the internal credit score and the Z-score.

3rd: create a normal distribution to find the probability of default. BUT on this part I would need some advise to see how it is possible.

I hope I am clear in what I would like to do. Thank you in advance.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.