Assessing the Probability of Bankruptcy

by Stephen A. Hillegeist of Northwestern University,
Elizabeth K. Keating of Harvard University,
Donald P. Cram of the California State University at Fullerton, and
Kyle G. Lundstedt of VaRisk, Inc.

January 2004

Abstract: We assess whether two popular accounting-based measures, Altman's (1968) Z-Score and Ohlson's (1980) O-Score, effectively summarize publicly-available information about the probability of bankruptcy. We compare the relative information content of these Scores to a market-based measure of the probability of bankruptcy that we develop based on the Black–Scholes–Merton option-pricing model, BSM-Prob. Our tests show that BSM-Prob provides significantly more information than either of the two accounting-based measures. This finding is robust to various modifications of Z-Score and O-Score, including updating the coefficients, making industry adjustments, and decomposing them into their lagged levels and changes. We recommend that researchers use BSM-Prob instead of Z-Score and O-Score in their studies and provide the SAS code to calculate BSM-Prob.

JEL Classification: M41, G1, C41, C52.

Keywords: bankruptcy prediction, option-pricing models, Z-Score, O-Score.

Previously titled: Corporate Bankruptcy: Do Debt Covenant and Disclosure Quality Measures Provide Information Beyond Options and Other Market Variables?

Published in: Review of Accounting Studies, Vol. 9, No. 1, (March 2004), pp. 5-34.

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