How do you know when a company is at risk of corporate collapse? To detect any signs of looming bankruptcy, investors calculate and analyze all kinds of financial ratios: working capital, profitability, debt levels and liquidity. The trouble is, each ratio is unique and tells a different story about a firm's financial health. At times they can even appear to contradict each other. Having to rely on a bunch of individual ratios, the investor may find it confusing and difficult to know when a stock is going to the wall. (For background reading, check out An Overview Of Corporate Bankruptcy.)
Tutorial: Financial Ratios
In a bid to resolve this conundrum, NYU Professor Edward Altman introduced the Z-score formula in the late 1960s. Rather than search for a single best ratio, Altman built a model that distills five key performance ratios into a single score. As it turns out, the Z-score gives investors a pretty good snapshot of corporate financial health. Here we look at how to calculate the Z-score and how investors can use it to help make buy and sell decisions.
The Z-score Formula
Here is the formula (for manufacturing firms), which is built out of the five weighted financial ratios:
|Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E|
A = Working Capital/Total Assets
B = Retained Earnings/Total Assets
C = Earnings Before Interest & Tax/Total Assets
D = Market Value of Equity/Total Liabilities
E = Sales/Total Assets
Strictly speaking, the lower the score, the higher the odds are that a company is headed for bankruptcy. A Z-score of lower than 1.8, in particular, indicates that the company is heading for bankruptcy. Companies with scores above 3 are unlikely to enter bankruptcy. Scores in between 1.8 and 3 lie in a gray area.
Breaking Down the Z
Now that we know the formula, it's helpful to examine why these particular ratios are included. Let's take a look at the significance of each one:
- Working Capital/Total Assets (WC/TA)
This ratio is a good test for corporate distress. A firm with negative working capital is likely to experience problems meeting its short-term obligations because there simply is not enough current assets to cover those obligations. By contrast, a firm with significantly positive working capital rarely has trouble paying its bills. (For background reading, see Working Capital Works.)
- Retained Earnings/Total Assets (RE/TA)
This ratio measures the amount of reinvested earnings or losses, which reflects the extent of the company's leverage. Companies with low RE/TA are financing capital expenditure through borrowings rather than through retained earnings. Companies with high RE/TA suggest a history of profitability and the ability to stand up to a bad year of losses.
- Earnings Before Interest and Tax/Total Assets (EBIT/TA )
This is a version of return on assets (ROA), an effective way of assessing a firm's ability to squeeze profits from its assets before factors like interest and tax are deducted.
- Market Value of Equity/Total Liabilities (ME/TL)
This is a ratio that shows - if a firm were to become insolvent - how much the company's market value would decline before liabilities exceed assets on the financial statements. This ratio adds a market value dimension to the model that isn't based on pure fundamentals. In other words, a durable market capitalization can be interpreted as the market's confidence in the company's solid financial position.
- Sales/Total Assets (S/TA)
This tells investors how well management handles competition and how efficiently the firm uses assets to generate sales. Failure to grow market share translates into a low or falling S/TA.
To demonstrate the power of the Z-score, let's look at how it holds up with a tricky test case. Consider the infamous collapse of telecommunications giant WorldCom in 2002. WorldCom's bankruptcy created $100 billion in losses for its investors after management falsely recorded billions of dollars as capital expenditures rather than operating costs.
Here we calculate Z-scores for WorldCom using annual 10-K financial reports for years ending December 31, 1999, 2000 and 2001. Indeed, WorldCom's Z-score suffered a sharp fall. Also note that the Z-score moved from the gray area into the danger zone in 2000 and 2001, before declaring bankruptcy in 2002.
|X1||Working capital/ Total Assets||-0.09||-0.08||0|
|X2||Retained earnings/Total Assets||-0.02||0.03||0.04|
|X4||Market Value/Total Liabilities||3.7||1.2||.50|
But WorldCom management cooked the books, inflating the company's earnings and assets in the financial statements. What impact do these shenanigans have on the Z-score? Overstated earnings likely increase the EBIT/total assets ratio in the Z-score model, but overstated assets would actually shrink three of the other ratios with total assets in the denominator. So the overall impact of the false accounting on the company's Z-score is likely to be downward. (For more on corporate accounting gone wrong, see Cooking The Books 101.)
Where Z-Score Falls Short
Alas, the Z-score is not perfect and needs to be calculated and interpreted with care. For starters, the Z-score is not immune to false accounting practices. As WorldCom demonstrates, companies in trouble may be tempted to misrepresent financials. The Z-score is only as accurate as the data that goes into it.
The Z-score also isn't much use for new companies with little or no earnings. These companies, regardless of their financial health, will score low. Moreover, the Z-score doesn't address the issue of cash flows directly, only hinting at it through the use of the net working capital-to-asset ratio. After all, it takes cash to pay the bills.
Finally, Z-scores can swing from quarter to quarter when a company records one-time write-offs. These can change the final score, suggesting that a company that's really not at risk is on the brink of bankruptcy.
To keep an eye on their investments, investors should consider checking their companies' Z-score on a regular basis. A deteriorating Z-score can signal trouble ahead and provide a simpler conclusion than the mass of ratios. Given its shortcomings, the Z-score is probably better used as a gauge of relative financial health rather than as a predictor. Arguably, it's best to use the model as a quick check of financial health, but if the score indicates a problem, it's a good idea to conduct a more detailed analysis.
Stock AnalysisExamine the current state of Netflix Inc., and learn about three of the major fundamental risks that the company is currently facing.
Stock AnalysisExamine the Seagate acquisition of Dot Hill Systems, and learn what Seagate is looking to gain by acquiring Dot Hill's software technology.
ProfessionalsIdentify the key differences between a career in accounting and financial planning, and learn how your personality dictates which is the better choice for you.
EconomicsA company’s days working capital ratio shows how many days it takes to convert working capital into revenue.
ProfessionalsLearn about the differences between controllers and accountants, how the two are related and which is the best career choice for aspiring bookkeepers.
ProfessionalsCash basis accounting recognizes revenues and expenses at the time cash is paid or received.
InvestingIn an industry still largely predominated by men, we look at 6 leading female value investors working today.
TermFinancial performance measures a firm’s ability to generate profits through the use of its assets.
EntrepreneurshipHow to determine if the amount you clear dovetails with the competition.
Stock AnalysisExamine the current state of FireEye, Inc., and learn about some of the biggest risks of investing in this cybersecurity company's stock.
A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
A company accrues unpaid salaries on its balance sheet as part of accounts payable, which is a current liability account, ... Read Full Answer >>
A profit and loss (P&L) statement, or balance sheet, is essentially a snapshot of a company's financial activity for ... Read Full Answer >>
Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
Dividends paid in cash affect a company's balance sheet by decreasing the company's cash account on the asset side and decreasing ... Read Full Answer >>
Cash or stock dividends distributed to shareholders are not considered an expense on a company's income statement. Stock ... Read Full Answer >>