Financial Statement Analysis — Credit Analysis and Distress Prediction: Coverage Ratios and the Altman Z-score

Shareholders ask how much profit will grow; creditors ask whether they will be repaid on time. However much profit grows, creditors receive no more than the agreed principal and interest, and if the company fails they bear losses. So credit analysis focuses on downside risk — the balance between cash-generating power and the debt burden (unit: ₩100 million).

1. The credit analysis framework

The traditional 5 Cs are five perspectives for assessing a borrower: Character (willingness and record of repayment), Capacity (ability to repay from cash flow), Capital (equity to absorb losses), Collateral and Conditions (industry and economy). Financial statement analysis mainly quantifies capacity and capital.

2. Coverage and leverage ratios

FA’s EBITDA for 20X2 (operating profit + depreciation) is $144 + 60 = 204$ . Borrowings are 80 short-term and 300 long-term, and cash is 50. Assume the principal due next year is the 80 of short-term borrowings.

FA's credit metrics
Metric	Formula	FA	Interpretation
Net debt/EBITDA	(Borrowings − cash) ÷ EBITDA	330 ÷ 204 ≈ 1.6 times	About 1.6 years of EBITDA to repay net debt
Interest coverage	Operating profit ÷ interest expense	144 ÷ 24 = 6.0 times	Capacity to pay interest
EBITDA interest coverage	EBITDA ÷ interest expense	204 ÷ 24 = 8.5 times	Cash-based interest capacity
Debt service coverage ratio (DSCR)	EBITDA ÷ (interest + principal repayment)	204 ÷ 104 ≈ 2.0 times	Below 1 means reliance on refinancing
Operating cash flow/total borrowings	106 ÷ 380	About 28%	Cash flow's capacity to repay debt

Credit rating agencies use such metrics together with industry benchmarks in their rating decisions. Korean credit ratings run from AAA to D, with BBB− and above regarded as investment grade.

3. The Altman Z-score

Altman (1968) built a discriminant function separating bankrupt from healthy companies using data on listed US manufacturers.

Altman Z-score (listed manufacturers)

Z = 1.2X_1 + 1.4X_2 + 3.3X_3 + 0.6X_4 + 1.0X_5

X1 = working capital/total assets, X2 = retained earnings/total assets, X3 = EBIT/total assets, X4 = market value of equity/total liabilities, X5 = sales/total assets. Z > 2.99 is safe, 1.81–2.99 the grey zone and below 1.81 distress risk.

Assume FA’s market capitalization is 800.

Z-scores of FA and FH
Variable	FA value	FA contribution	FH value	FH contribution
X1 working capital/total assets	200/1,000 = 0.20	0.24	−0.05	−0.06
X2 retained earnings/total assets	300/1,000 = 0.30	0.42	0.02	0.03
X3 EBIT/total assets	144/1,000 = 0.144	0.48	0.01	0.03
X4 market capitalization/total liabilities	800/500 = 1.60	0.96	0.25	0.15
X5 sales/total assets	1,200/1,000 = 1.20	1.20	0.80	0.80
Z		About 3.30 (safe)		About 0.95 (distress risk)

FH shows the classic signs of distress: negative working capital, almost no accumulated profit and operating profit that cannot cover interest.

4. Marginal firms

The Bank of Korea classifies companies with interest coverage below 1 for three consecutive years as marginal firms — meaning that for three years the money earned from operations could not even pay the interest. When interest rates rise, interest expense grows and the share of marginal firms increases. The share of marginal firms among externally audited companies is published regularly in the Bank of Korea’s Financial Stability Report.

Check your understanding

FI’s total assets are ₩200 billion, working capital ₩10 billion, retained earnings −₩20 billion, EBIT ₩4 billion, market capitalization ₩30 billion, total liabilities ₩150 billion and sales ₩160 billion. Interest expense is ₩6 billion. What are its Z-score and interest coverage, and how would you assess it?

$X_1 = 0.05$ , $X_2 = -0.10$ , $X_3 = 0.02$ , $X_4 = 0.20$ and $X_5 = 0.80$ . $Z = 0.06 - 0.14 + 0.066 + 0.12 + 0.80 ≈ 0.91$ , in the distress zone. Interest coverage is $40 / 60 ≈ 0.67$ times, so operating profit cannot cover interest. If this continues for three years it becomes a marginal firm. With equity eroded by losses and heavy debt, raising further funds will also be difficult.

References

Edward Altman, “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy,” Journal of Finance (1968)
Bank of Korea, Financial Stability Report
Krishna Palepu, Paul Healy and Erik Peek, Business Analysis and Valuation: IFRS Edition, ch. 10