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Could Sports Direct go bust?

With so much news-driven share price movement for your average stock these days, it is often easy to overlook the base financials of a company. To the uninitiated, a company’s financial report can be intimidating, and headlines about revenue or EBITDA can be the extent to which some investors look at the numbers. However one metric I like to use to gauge a company’s strength is known as the Altman Z-Score.

This calculation is effectively a credit-strength test that gives a listed company a number based on five key financial ratios. As a rule, anything above 3 is pretty solid, while anything below 1.8 is a riskier prospect. Of course the number needs to be taken in context, and should always be viewed in relation to a sector or industry average.

Below I have calculated the Z-Score for Sports Direct (LSE: SPD), compared it to similar firms including JD Sports and US company Genesco, and the results were very telling. These numbers are based on the companies’ most recent full-year reports.

Ratio

Sports Direct

Industry Average

Z-Score

3

4.69

Working Capital/Total Assets

0.45

0.25

Retained Earnings/Total Assets

0.48

0.47

EBIT/Total Assets

0.06

0.04

Market Value of Equity/Total Liabilities

0.68

2.92

Revenue/Total Assets

1.18

1.84

Coming in at exactly 3, perhaps surprisingly, Sports Direct’s Z-Score is on the cusp of what is generally considered a solid position – stronger than what one might have expected. It is of course far below the industry average of 4.69, but a closer look at the ratios suggests this is mainly due to the low market value of the company’s equity at the moment.

Exactly why the share price is low is key to interpreting the numbers. If it is a genuine reflection of the company’s strength or prospects, we can take the number at face value. If however it is a result of speculation and overselling, we must take into account the fact that this is only a temporary issue. Unfortunately for Sports Direct, I think in this case it is much more the former.

Most recently, the company has been struggling to appoint an auditor of its financial accounts, after a ‘last minute’ €674m Belgian tax bill delayed its latest numbers and saw the firm’s auditor Grant Thornton quitting amid the controversy. The big four accounting firms meanwhile, all refused to take up the mantle.

Recently CEO Mike Ashley admitted regret at the company’s purchase of House of Fraser – an acquisition controversial at the time and one that has been weighing on sentiment ever since. Somewhat ironically perhaps, in April he attempted to rescue struggling Debenhams with a £200m package (an offer which was rejected), with Mr Ashley already estimated to have spent £150m on his stake in the firm.

All things considered, I think the Z-Score of 3 may be optimistic, though the firm is perhaps not quite yet at risk of going bust. Even if its share price were to recover all the way back to 400p, the improvement in the score would be only marginal. For the moment at least, I think Sports Direct is an investment well worth avoiding.

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Karl has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.