# Use the Z-score to spot failure

In times of economic and financial uncertainty, it's good to have an objective measure of a company's financial standing - even if it doesn't work for all companies all of the time. One tried and trusted method of doing this is the Z-score.

Dr Edward Altman, an American academic, devised the Z-score during the 1960s, although his original work has since been updated. Altman believes that the Z-score will signal 70-80% of bankruptcies of publicly listed companies - before they happen. His book Corporate Financial Distress and Bankruptcy (published by John Wiley) contains chapter and verse on this, and a detailed examination of how Enron, Worldcom and other notable disasters stacked up on the Z-score.

How does it work?

The Z-score takes a number of key ratios - part income statement and part balance sheet - and combines them in a unique formula of its own.

The Z-score formula looks something like this, at least for public companies. There's a separate equation for private ones.

Z = 1.2 x Ratio 1 + 1.4 x Ratio 2 + 3.3 x Ratio 3 + 0.6 x Ratio 4 + Ratio 5

Where:

Ratio 1 = working capital/total assets

Ratio 2 = accumulated retained earnings/total assets

Ratio 3 = EBIT/total assets

Ratio 4 = Market capitalisation/total liabilities

Ratio 5 = sales/total assets

It looks a bit fearsome, but using a simple spreadsheet should make short work of the calculation. But it begs a wider question. Why do we use ratios like this as the starting point for the Z-score in the first place? One reason is that they are rooted in the reasons why a company might get into financial distress.

Those ratios explained

The ratio of working capital to total assets is meant to show whether or not a company is consistently seeing a cash outflow from the business. The theory is that ongoing losses will result in shrinking current assets relative to total assets. That's okay, as far as it goes. But it is difficult to apply in the case of companies that enjoy generous credit terms from suppliers.

The ratio of retained earnings to total assets is a measure of the accumulated amount a company has generated to reinvest in the business. Clearly, the higher this figure the better. The more a company retains, the greater its ability to finance capital spending and other essentials from its own internal resources. Companies that have large write-offs will deplete their retained earnings and so reduce their Z-score.

The EBIT to total assets ratio is an objective way of measuring return on assets without the size of the firm's borrowings or cash - or the tax regime it operates under - affecting the result.

The ratio of market capitalisation to total liabilities shows the extent to which the company's stockmarket value can decline before the figure drops below the company's liabilities. It adds a stockmarket dimension to the calculation.

The ratio of sales to total assets represents the effectiveness with which management is using the company's assets to generate sales and cash. While these may seem to be random ratios, it is when they are weighted in the correct proportions and combined that they provide a test of financial solidity that has proved over the years to be reliable.

Z-score could stop you making costly mistakes

The Z-score typically falls into disuse during rampant bull markets, and then undergoes something of a revival once investors begin to realise that companies getting into financial difficulties is an integral part of the investing process, and that to avoid losing money, you need to have a means of spotting it.

Convention has it that a healthy public company should have a Z of 2.99 or more, and one likely to go bust would have a score of 1.81 or less. In between is what Altman terms the 'zone of ignorance'. Here, the predictive value of the Z-score is less clear-cut, but at the lower levels, bankruptcy is still regarded as more likely than not.

There are some drawbacks to it.

The first is that it is generally not suitable for analysing the accounts of utilities, property companies, banks, insurers and other financial services companies. A second objection is that relatively new companies with a low level of profitability may not get a high score. A third objection is that fraudulent accounts will produce a misleading score.

The scoring method favours long-established companies. And some of the items used to calculate the ratios - notably sales and working capital items - are capable of manipulation by management.

Nonetheless, calculating the Z-score for the same company for successive years' accounts can highlight where a company's financial condition is deteriorating. If a company's Z-score has fallen over the course of year or two from a healthy position to one bordering on in the unhealthy category, the shares should be avoided.

By the same token, companies whose Z-score is consistently improving from an unhealthy position may be a good bet for share price recovery.

It demands a bit of time with a calculator, a set of accounts and a spreadsheet, but it could stop you making a costly mistake.