In 1968, New YorkUniversity finance professor Edward Altman created the Z-Score, a formula for predicting the likelihood a company would go bankrupt within two years. Almost 40 years later, former fund manager Peter Temple dragged out the formula in his book "Magic Numbers For Stock Investors". I pulled it off my bookshelf recently and thought it would make a good topic for an article. My wife used to work for a division of Liz Claiborne, and since the company has spent the last three years perilously close to bankruptcy, comparing it to some of its competitors seems like a good place to start - by analyzing retail's magic numbers.

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The Ingredients
Deriving the Z-Score involves calculating five specific financial ratios and then assigning a weight to each of them based on their relative importance to the formula. What comes out the other end is a number usually between zero and nine, with any score above 2.99 indicating a healthy public company. Any number less than 1.81 is considered unhealthy, and everything in between is average. For the purposes of this article, I will compare fiscal 2006 with fiscal 2008. If you intend to use the Z-Score in the future, make sure you use a spreadsheet. Otherwise this is one time-consuming calculation.
The Calculation
Z-Score = 1.2 * working capital/total assets + 1.4 * accumulated retained earnings/total assets + 3.3 * EBIT/total assets + 0.6 * market cap/total liabilities + sales/total assets

Liz Claiborne & Competitors' Z-Scores

Company 2006 2008
Liz Claiborne (NYSE: LIZ) 5.36 2.38
Jones Apparel (NYSE: JNY) 3.45 2.07
Ralph Lauren (NYSE: RL) 6.04 4.49
Lululemon (Nasdaq: LULU) 33.71 8.98

What To Make Of The Results
Numbers don't always tell an accurate story, and these Z-Scores are no different. However, when used in conjunction with other quantitative as well as qualitative tests, they can be very telling. Here is my laundry list of observations:

1) All four companies' credit worthiness deteriorated over the three-year period. That's obviously indicative of the global economic conditions existing for the better part of 24 months.
2) Liz Claiborne is still financially sound despite its profit woes. It's not out of the woods yet, but I think it's close to righting the ship. Whether it can ever play with the big boys like Ralph Lauren and VF Corp. (NYSE: VFC) is another matter entirely. This next year is a pivotal year for Bill McComb. Any setback in its remake, and the Z-Score could move closer to 1.81 and into financial peril.
3) Jones Apparel really was nearing the bankruptcy Z-score number in 2008, forcing it to sell its shoes in unfamiliar, downscale stores like Wal-Mart (NYSE: WMT). Can it survive this blemish to its good name? Time will tell.
4) Lululemon is still a hot retail brand. However, its Z-Score would seem to indicate its popularity is cooling off. There is a caveat to its score. Younger companies tend to have more erratic numbers and probably aren't as predictive in their nature. It's something to keep in mind.
5) Ralph Lauren is still the king of retail. With a Z-Score of 4.49 in 2008, it's far healthier than the average retailer/wholesaler. I didn't include Gap (NYSE: GPS) in the table above, but I'm sure it would be a close comparison with Gap, edging out the legendary merchant.

Bottom Line
Whether you're analyzing retailers, food producers, car manufacturers or companies in almost any industry except perhaps banking, the Z-Score produces some magical numbers indeed. (To learn more, see Z Marks The End.)

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