What does the Z-score model assess to estimate the likelihood of default?

• A. A firm's corporate governance practices
• B. A set of financial ratios from a firm's financial statements
• C. The historical performance of similar firms
• D. The stock market trends

Answer: (B)

The Z-score model primarily assesses a set of financial ratios derived from a company's financial statements, which include metrics like working capital, retained earnings, earnings before interest and taxes (EBIT), total assets, and total liabilities. The core idea is that these financial ratios provide insight into the company's operational efficiency, profitability, and financial stability. By analyzing these ratios, the Z-score model quantifies the likelihood of default by creating a single score that reflects the company's financial health compared to historical data of both healthy and bankrupt firms.

This model is particularly useful because it combines multiple aspects of financial performance into one statistic, allowing investors and analysts to make informed decisions about credit risk. The Z-score calculation helps in identifying firms that are under financial distress and could potentially default based on their financial data. Thus, using financial ratios derived from a firm's financial statements is essential in estimating the likelihood of default through the Z-score model.