Question

When using the Z-Score Model for private firms, which variable could be a potential problem and why?

Answer 1

Original Z-Score model of Altman was developed for the purpose of insolvency testing of publicly traded companies. In later stage it was tried to be applied in private firms insolvency or credit strength analysis. The original Z-score model has following variables: Working Capital/Total Assets, EBIT/Total Assets, sales/Total Assets,market value of Equity/Total Assets and retained earnings/Total Assets. Out of these 5 variables, market value of Equity/Total Assets is the potential problem when Z-score model is tried for private firms. As they are not listed in any stock market, market value of Equity can't be applied for privately held companies Z-score evaluation.

To eliminate this problem, initially random adjustment of book value of equity of private firm done by substituting it as market value of equity. But this process was invalid and non-scientific. Finally this problem was solved when Altman came with modified form of original Z-score model as Z-score plus in 2012, which can be correctly applied for private companies credit strength analysis. In this modified model, for private firms, book value of equity/Total Assets variable applied instead of market value of Equity/Total Assets.All the remaining statistical methods and discrimant analysis done as the original model. This way, Z-score model application for private firms got resolved later.