Question

Looking for assistance in Assessment Of Solvency of a company including the following:

Calculation of Altman Z-Score Model

Estimate of Debt Rating

Actual Bond Rating

Answer 1

The Z-score formula is calculated by subtracting the total score from mean and then dividing it by standard deviation. As you can see, the Altman score weights different profitability and liquidity metrics to arrive at the overall score. This overall score is then compared to the following grading scale.

Formula

The Z-score formula is calculated by subtracting the total score from mean and then dividing it by standard deviation.

Z-Score (Score - Mean) Z-Score Standard Deviation

The Altman Z-score equation is calculated by weighting various financial ratios and comparing their sum to a graded scale. The equation looks like this:

Z-Score Z-Score 1.2 A + 1.4 B + 3.3 C + 0.6 D + 1.0 E Where: A = Working Capital / Total B = Retained Earnings / Total Assets C = Earnings before Interests and Taxes / Total Assets D = Market Value of Equity / Book Value of Total Liabilities E = Sales / Total Assets

Debt-Rating Approach

Based on the company's debt rating, the before-tax cost of debt is estimated by using the yield on comparably rated bonds for maturities that are a close match to those of the firm's existing debt. For example, assume that: A firm's debt has an average maturity of 5 years. Its credit rating is AAA.

To calculate the cost of debt, a company must determine the total amount of interest it is paying on each of its debts for the year. Then it divides this number by the total of all of its debt. The result is the cost of debt. The cost of debt formula is the effective interest rate multiplied by (1 - tax rate).

Actual Bond Rating

The bond rating measures the financial strength of the company issuing the bond, and its ability to make interest payments and repay the principal of the bond, when due. Standard & Poor's, Moody's, and Fitch Ratings are the major bond-rating agencies.

A bond rating is a rating that independent agencies issue to measure the credit quality of a particular bond. The bond rating measures the financial strength of the company issuing the bond, and its ability to make interest payments and repay the principal of the bond, when due.

Standard & Poor's, Moody's, and Fitch Ratings are the major bond-rating agencies. Although their rating systems are slightly different, the coveted triple-A rating indicates the cream of the crop that every bond issuer strives to achieve. Below, we'll look more closely at bond ratings and what they mean.

Understanding bond ratings

Thousands of government agencies and private companies look to raise capital by issuing debt, and the bonds that they sell are popular investments among those looking for fixed income. However, the depth of the bond market can make it difficult for investors to assess whether one company is more or less likely to repay its debt than another. In order to simplify comparison of different bonds, bond-rating agencies make it their specialties to issue bond ratings for different bonds.

Bond ratings use a combination of letters, numbers, and symbols to indicate their relative placement on a given agency's rating scale. Letters generally indicate a broad range of ratings. Having more letters in the rating is generally better than fewer letters, and being earlier in the alphabet indicates higher quality.

For Standard and Poor's, AAA is the best rating, followed by AA, A, BBB, BB, B, CCC, CC, and C. D is used for bonds that are already in default. Fitch's ratings are similar to S&P. Moody's uses a slightly different scale, but its Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C ratings have roughly the same meaning.

From there, numbers or symbols further break down the letter-based rating. For example, with S&P and Fitch, a rating of AA+ is better than AA, and a rating of AA- is worse than AA, but better than A+. Moody's uses numbers to indicate relative quality, with Aa1 being the best Aa rating, followed by Aa2 and Aa3.