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# Finance Dictionary - C Terms

# Credit Scoring Model

Using financial ratio analysis to evaluate credit risk is certainly helpful. Yet, the decision that must be made following the examination of such data can be complicated by the difficulty of interpreting conflicting ratios. Different ratios often imply different predictions for the same firm. To overcome such ambiguity, information from several financial ratios can be combined into a single index. The resulting multivariate financial model will yield a single number for classifying the firm in terms of credit risk. For example, the multivariate financial model developed by Altman (1968) is defined as: Yi ¼ 0:012X1 þ 0:014X2 þ 0:033X3 þ 0:006X4 þ 0:999X5, where X1 ¼ Working capital/Total assets; X2 ¼ Retained earnings/Total assets; X3 ¼ EBIT/Total assets; X4 ¼ Market value of equity/Book value of total debt; and X5 ¼ Sales/Total assets. By substituting the financial ratio information for an individual company into this model, we can obtain financial Z-scores. This financial Z-score can be used to determine financial condition of a firm.