Credit Risk Assessment for Commercial Loans

The purpose of this research is to provide practical tool for credit evaluation of firms by using cash flow statements as the basis. A predictive function for firm credit score is introduced using the expected cash flow adjusted for internal and external state effects.  The data used in this research came from 10 publicly traded companies in SP500 for in-sample testing. Out-of-sample test was accomplished by an additional 10 companies from NASDAQ. We assert that the Cash Flow Base (CFB) distribution method as a tool for commercial loan assessment is inadequate. This research introduces the use of the distribution of the Altman Z-score as a means for commercial risk assessment. The use of failure rate H(t) in this paper allows lenders to specified the level of default risk tolerance and decide whether to grant the loan. We verified our method in out-of-sample testing. Our Comparative Altman Z-Score forecasting method was able to identify risky firms with 0.95 confidence. The contribution of this research lies in its practical and interdisciplinary applications in risk management for banking and finance.