Which statement about the Altman model to assess the probability of bankruptcy is correct?

Question

BlackTom AI · Accepted Answer

To tackle this question, I will evaluate each proposed statement about the Altman model and how it assesses bankruptcy risk, weighing what each ratio represents.
Option 1: 'Sales/total assets—indicates the company’s ability to generate sales and is a profitability ratio.' While sales/total assets (asset turnover) relates to efficiency in using assets to generate sales, it is not a standard component of the Altman Z-score model, and it does not by itself measure profitability in the way the Altman model uses it. This statement mischaracterizes the metric and its role in bankruptcy assessment.
Option 2: 'Net working capital/total assets—is a measure of long-term solvency risk.' Net working capital divided by total assets is a liquidity/short-term solvency-like metric, not a primary component of the Altman model. The Altman model emphasizes profitability, leverage, liquidity, and activity in a specific formulation; this ratio does not align with those core elements and is not how the model gauges bankruptcy risk.
Option 3: 'Market value of equity/book value of liabilities—is a form of leverage ratio; it is expressed as equity/debt, so a higher number indicates greater insolvency.' The statement incorrectly describes the ratio and the direction of risk: in general, a higher market-to-book equity ratio or higher leverage can indicate more risk, but the Altman model uses specific constructs (e.g., working capital, retained earnings, total assets, EBIT, etc.) in its original formulations. Moreover, 'market value of equity/book value of liabilities' is not the standard leverage ratio used in the Altman framework.
Option 4: 'Retained earnings/total assets—reflects accumulated profitability and relative age because retained earnings accumulate over time.' This matches a key element of the Altman Z-score, where retained earnings (or retained earnings plus other equity-related measures) connect to accumulated profitability and the cumulative earnings over an entrepreneur’s or firm’s life, reflecting profitability retention and asset base growth. In many Altman formulations, retained earnings (or equity measures) appear as part of the balance sheet inputs that capture cumulative profitability and firm age, contributing to the prediction of bankruptcy risk.
Option 5: 'EBIT (earnings before interest and taxes)/total assets—measures activity.' EBIT/total assets is an activity or profitability-related ratio (akin to operating return on assets), but in the classic Altman model, EBIT/total assets is not a standalone input; the model uses EBIT in combination with other variables, yet the specific statement here mislabels its sole purpose as the model’s activity measure. In any case, it does not accurately describe the Altman model's standard components.
Overall, the statements about what the Altman model uses for assessing bankruptcy risk must align with its recognized inputs and the way those inputs drive the Z-score. The option that correctly reflects the model’s emphasis on accumulated profitability via retained earnings relative to assets is the correct conceptual match, while the others either misuse the ratio, misstate its purpose, or describe metrics not aligned with the Altman framework.

COMM_V 370 101-108 2025W1 COMM 370-Practice Midterm-2025-W1

Which statement about the Altman model to assess the probability of bankruptcy is correct?

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