Determining the Credit Score and Credit Rating of Firms using the Combination of KMV-Merton Model and Financial Ratios

Abstract

Credit risk management has become a must in this era due to the increase in the number of businesses defaulting. Building upon the legacy of Kealhofer, McQuown, and Vasicek (KMV), a mathematical model is introduced based on Merton model called KMV-Merton model to predict the credit risk of firms. The KMV-Merton model is commonly used in previous default studies but is said to be lacking in necessary detail. Hence, this study aims to combine the KMV-Merton model with the financial ratios to determine the firms’ credit scores and ratings. Based on the sample data of four firms, the KMV-Merton model is used to estimate the default probabilities. The data is also used to estimate the firms’ liquidity, solvency, indebtedness, return on asset (ROA), and interest coverage. According to the weightages established in this analysis, scores were assigned based on those estimates to calculate the total credit score. The firms were then given a rating based on their respective credit score. The credit ratings are compared to the real credit ratings rated by Malaysian Rating Corporation Berhad (MARC). According to the comparison, three of the four companies have credit scores that are comparable to MARC’s. Two A-rated firms and one D-rated firm have the same ratings. The other receives a C instead of a B. This shows that the credit scoring technique used can grade the low and the high credit risk firms, but not strictly for a firm with a medium level of credit risk. Although research on credit scoring have been done previously, the combination of KMV-Merton model and financial ratios in one credit scoring model based on the calculated weightages gives new branch to the current studies. In practice, this study aids risk managers, bankers, and investors in making wise decisions through a smooth and persuasive process of monitoring firms’ credit risk.