A company declaring bankruptcy is a nightmare scenario for many investors. But unfortunately, it does happen.
However, even for the most experienced analysts, it’s almost impossible to try and pinpoint the companies that are at the most risk of going out of business.
So, to try and simplify things, Professor Edward I. Altman developed the Altman Z-Score.
Simply put, the Z-Score is an indicator generated from a set of balance sheet ratios. If the Z-Score is greater than 3, the financial health of the company is good. Anything less than 1.8 indicates financial distress. Tests have shown that between 80% and 90% of the time, companies scoring less than 1.8 go out of business.
There are four key tests used to compute the Z-Score. Firstly, the company must have plenty of cash on hand to meet upcoming liabilities. Secondly, the majority of the company’s assets must have been acquired with retained profit, to prove that the business is capable of growing without outside help.
Thirdly, the company must demonstrate a high level of earnings compared to assets. This is once again to show that the business is capable of growing without outside help. And lastly, the company in questions debt must not exceed a certain percentage of its market value.
The lowest scores
Premier Foods (LSE: PFD) has one of the lowest Z-Scores around, weighing in with a score of -0.4. The company has a negative working capital balance, or in other words it does not have enough cash on hand to pay its liabilities falling due within 12 months. Moreover, the company has a net debt pile of £571m, £220m more than the group’s current market capitalisation.
Avanti (LSE: AVN) has a Z-Score of 0.4, once again indicating distress. Avanti is yet to generate a profit so it fails three of the Z-Score’s four criteria. Net debt amounts to 60% of the group’s market cap but the company’s assets are starting to generate cash, independent of any tax or leverage factors. Since a firm’s ultimate existence is based on the earning power of its assets, Avanti may not have passed the Z-Score this time but its prospects are improving.
Next up is Tullow Oil (LSE: TLW). Tullow’s $1.5bn loss reported last year has skewed the figures slightly and as a result the company has a Z-Score of 0.7 — indicating distress. That being said, the company has plenty of cash on hand to meet liabilities falling due within 12 months, assets are productive and debt is low. So I believe that in this case the Z-Score is unreliable.
Vedanta Resources (LSE: VED) has a low Z-Score of 1.2 and it’s easy to see why. Indeed, Vedanta is well known for its complex corporate structure, which hides a high level of debt. Net debt of £5.8bn is almost four times greater that Vedanta’s market cap.
Moreover, according to my figures a large portion of the company’s assets are illiquid — if the group needed to raise cash quickly, in order to pay down liabilities, it would have trouble selling illiquid assets.
And lastly, Enquest (LSE: ENQ) which only just falls into the distress zone. Enquest has a Z-score of 1.8 and once again falls down due to a high level of debt. For example, the company’s net debt stands at $870m, twice the current market cap.
Additionally, the group has a quick ratio of less than one, which means that excluding inventories, Enquest does not have enough cash on hand to meet liabilities falling due within 12 months.
The bottom line
All in all, the Altman Z-Score indicates that Enquest, Vedanta, Tullow, Avanti and Premier are all high-risk companies.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Tullow Oil. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.