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.

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.

The Z-score Formula
Here is the formula (for manufacturing firms), which is built out of the five weighted financial ratios:

Z = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:
Z = score
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 are the odds of bankruptcy. A Z-score of lower than 1.8 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) is a ratio that 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 are simply not enough current assets to cover them. By contrast, a firm with significantly positive working capital rarely has trouble paying its bills.
• Retained earnings/total assets (RE/TA) 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 ) 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) 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) 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.

WorldCom Test
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. Declared bankrupt in July 2002, WorldCom lost investors more than $100 billion in value 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.

Input	Financial Ratio	1999	2000	2001
X1	Working capital/ Total Assets	-0.09	-0.08	0
X2	Retained earnings/Total Assets	-0.02	0.03	0.04
X3	EBIT/Total Assets	.09	.08	.02
X4	Market Value/Total Liabilities	3.7	1.2	.50
X5	Sales/Total Assets	0.51	0.42	0.3
Z-score	2.5	1.4	.85

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.

Where Z 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.

Conclusion
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 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.

by Ben McClure, (Contact Author | Biography)

Ben is director of McClure & Co., an independent research and consulting firm that specializes in investment analysis and intelligence. Before founding McClure & Co., Ben was a highly-rated European equities analyst at London-based Old Mutual Securities.