Whether knowingly or not, most people have evaluated credit risk in their lives. Credit risk refers to the possibility of a financial loss resulting from a borrower’s failure to repay a loan or fulfill contractual obligations. For example, if Mark lends $100 to a friend, there’s a chance he may never see that money again. Similarly, banks face credit risk when they extend loans to businesses, as borrowers may default.

Credit risk analysis is the structured process used to evaluate this risk. It helps lenders determine the likelihood that a borrower will honor their debt obligations. This process involves a mix of financial and non-financial assessments.

Approaches to Credit Risk Analysis

Credit analysis varies in scope and depth depending on the nature of the transaction. Some professionals focus on evaluating the probability of default on a specific financial instrument—such as a corporate bond—while others assess the general creditworthiness of an entire company.

A comprehensive credit assessment typically examines:

  • Financial performance through ratio analysis
  • Business strategy and risk management
  • Operational efficiency and governance practices

This dual focus means credit analysis includes both financial and business risk evaluations.

Key Ratios in Credit Risk Analysis

One of the core components of credit analysis is the computation of ratios. Analysts calculate various financial ratios to assess a company’s liquidity, profitability, solvency, and operating efficiency. These ratios are then benchmarked against industry peers to derive an overall credit score.

For instance:

If red flags appear—such as weak profitability—a more detailed examination using tools like DuPont analysis can help identify root causes.

The Altman Z-Score Model

A widely used tool in credit risk analysis is the Altman Z-score—developed by Edward Altman, a professor at NYU Stern, in the 1970s. This model combines five financial ratios—each with a specific weight—to predict the likelihood of bankruptcy.

  1. Working Capital / Total Assets – Liquidity
  2. Retained Earnings / Total Assets – Solvency
  3. EBIT / Total Assets – Profitability
  4. Market Value of Equity / Total Liabilities – Valuation
  5. Sales / Total Assets – Efficiency

The formula calculates a Z-score that categorizes a firm’s bankruptcy risk:

  • Below 1.8 – High risk of bankruptcy
  • 1.8 to 2.6 – Grey zone
  • Above 2.6 – Safe zone

What’s remarkable is that the model has shown about 95% accuracy in predicting financial distress—a breakthrough at the time and still relevant today.

Case Study: Applying the Z-Score to SaleSmart

Let’s apply the Altman Z-score model to the hypothetical company SaleSmart using recent financial data.

  1. Liquidity = (Current Assets – Current Liabilities) / Total Assets = 0.22
    Weighted by 1.2 → 0.264
  2. Solvency = Retained Earnings / Total Assets
    Assume result × 1.4
  3. Profitability = EBIT / Total Assets
    Assume result × 3.3
  4. Efficiency = Sales / Total Assets
    Assume result × 1.0
  5. Valuation = Market Capitalization / Total Liabilities = 29,500 / Liabilities
    Weighted by 0.6

After combining these components, SaleSmart’s Z-score is 2.60. This places the company in a safe zone—signaling a low risk of near-term bankruptcy. Despite its debt, SaleSmart demonstrates solid profitability and consistent financial performance.

The Value of Credit Risk Analysis

Credit risk analysis is a critical process for lenders, investors, and analysts. By interpreting a combination of financial ratios—particularly through tools like the Altman Z-score—analysts can gain meaningful insights into a company’s likelihood of default.

While newer and more complex credit models have emerged, the Altman Z-score remains a foundational tool for predicting bankruptcy and assessing corporate credit health. When applied correctly, it provides a robust early warning system for financial distress, enabling stakeholders to make better-informed decisions.

To build on your knowledge of foundational tools like the Altman Z-score and apply them with confidence, consider joining the 365 Financial Analyst platform—where expert-led courses and hands-on case studies will sharpen your credit analysis skills and decision-making ability.

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