Shortcuts To The Z-Score

By Will Ashworth | November 29, 2010 AAA

The Z-Score is a measure that uses a combination of five ratios that, over a two-year period, successfully predict forthcoming company bankruptcies approximately 72% of the time. Using this means, you can perform the calculation (though it's time consuming) on your favorite stock. Here are some shortcuts that'll save you some time, not to mention your sanity.
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Retained Earnings/Total Assets
The five ratios are a combination of the balance sheet and income statement. One telltale sign of a bad score (those under 1.8) is negative retained earnings. When combined with a smaller amount of total assets, it's almost lethal. If your business is losing money, and has been for some time, one of the only ways to survive is to sell-off assets. If you don't have them to sell, you are one step closer to the grave.

Retained Earnings/Total Assets
Company Retained Earnings Total Assets Score
Jamba (Nasdaq:JMBA) $346 million $113 million 3.1
Perfumania (Nasdaq:PERF) $67 million $311 million 0.2
Talbots (NYSE:TLB) $52 million $674 million 0.1
Zale (NYSE:ZLC) $564 million $1.2 billion 0.5
Gap (NYSE:GPS) $11.2 billion $7.3 billion 1.5
Buckle (NYSE:BKE) $308 million $509 million 0.6

Market Cap/Total Liabilities
This is the fourth ratio in the Z-Score. A number higher than three is virtually guaranteed a strong Z-Score. That's because a company's market cap is often a reflection of how investors feel about its level of debt. Therefore, the higher the total liabilities, the lower the market cap, which results in a lower score and ultimately a weaker overall Z-Score. It's definitely counter intuitive.

Market Cap/Total Liabilities
Company Market Cap Total Liabilities Score
Jamba (Nasdaq:JMBA) $125.8 million $96.0 million 1.3
Perfumania (Nasdaq:PERF) $79.4 million $262.0 million 0.3
Talbots (NYSE:TLB) $795.2 million $510.0 million 1.6
Zale (NYSE:ZLC) $92.2 million $852.0 million 0.1
Aeropostale (NYSE:ARO) $2.5 billion $369.0 million 6.8
Jos. A Bank (Nasdaq:JOSB) $1.2 billion $161.0 million 7.5

Sales/Total Assets
Higher is definitely the better on this one. Let's say you have Company A with $1 billion in sales and $500 million in total assets and Company B with $2 billion in sales and the same total assets. Company B's score is double Company A's is, because it's generating twice the amount of sales from the same amount of assets. Of course, we don't know how profitable those additional sales are, but assuming margins are similar, the return on assets would be approximately double also. Why spend $1 to make $2 when you can spend the same dollar and make four? Thoughtful spending is an indicator of responsible management, and usually leads to a strong Z-Score. The corollary is the fact that a poor Z-Score is often the result of harmful spending.

Sales/Total Assets
Company Sales Total Assets Score
Jamba (Nasdaq:JMBA) $271 million $113 million 2.4
Perfumania (Nasdaq:PERF) $508 million $311 million 1.6
Talbots (NYSE:TLB) $1.2 billion $674 million 1.8
Zale (NYSE:ZLC) $1.6 billion $1.2 billion 1.3
Urban Outfitters (Nasdaq:URBN) $2.1 billion $1.7 billion 1.2
Lululemon (Nasdaq:LULU) $564 million $364 million 1.5

Bottom Line
These three of the five items that make up the Z-Score are listed in order of importance. You won't have a good Z-Score if retained earnings aren't positive, it's that simple. If they are positive, check the market cap and total assets. If the number's above three, you won't need to do any more calculations. Remember, the Z-Score is a predictor of future viability. A high score doesn't guarantee positive returns on your investment but it does tell you the likelihood of your stock being around in two years, and you can't hit the jackpot if you're not in the game. (For related reading, check out Z Marks The End.)

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