Business distress and bankruptcy can spell disappointment or even disaster for investors – and at a time of economic uncertainty, making that critical call between risk and reward is an increasingly challenging prospect. In the current environment investors ought to be scrutinising the financial health of their portfolio stocks and applying extra due diligence when it comes to new investments – but how? One excellent starting point is applying one of the longest running and best tested bankruptcy screening tools available to investors – the Altman Z-Score.
Attempting to figure out which stocks are at risk of failure is nothing new in investment circles. However, getting to grips with the subject of quoted company failure is difficult because for every headline-grabbing disaster there are a number of others companies – often at the smaller end of the market – that simply fade away, leaving only the investors involved feeling battered and bruised. A classic example was the administration of stricken healthcare recruitment business Pinnacle Staffing Group this summer, which marked the sorry end to five years of underachievement and investor frustration. Back in September 2006, investors were given the option to buy in to the promising recruitment spin-out from health and social care services group Nestor Healthcare. It culminated in perpetual losses and Pinnacle’s remaining assets ultimately being sold off for just £17,000. Meanwhile, investors that stuck with Nestor did rather better when that company was sold earlier this year to private equity-backed Saga for £124 million. Financial distress or insolvency drove twenty-two companies to delist from the Alternative Investment Market during the first half of 2011, according to accountancy group UHY Hacker Young, although the figure dropped dramatically to just three companies in the third quarter – F.T.S.- Formula Telecom Solutions, Pinnacle Staffing and Agua Terra. Despite signs of improvement, industry-watchers are broadly agreed that economic conditions remain brutal and uncertain and that investors should be acting with care.
So how does an investor spot a company that might go under? The Altman Z-Score has been a part of the investor toolkit for more than 40 years but is not as well-known as it should be. It was developed by New York University finance professor, Edward I. Altman, who used a combination of five weighted business ratios to estimate the likelihood of financial distress. It was initially created to test the financial health of manufacturing companies; with later tweaks opening it up to non-manufacturing and even private companies. Ultimately, any Z-Score above 2.99 is considered to be a safe company. Anything below 1.80 is in the distress zone, with a strong likelihood of the company going bankrupt within the next two years, while anything between 1.80 and 2.99 is in a "grey zone".
Some investors may question the idea of using a formula to predict bankruptcy – and to be fair it does produce some surprising results – but nevertheless tests have proved it to be highly effective. Its initial test found that it was 72% accurate in predicting bankruptcy two years prior to the event, while subsequent examination has shown 80-90% accuracy.
As an illustration of how the Altman Z-Score can be used, we used Stockopedia PRO to work up the numbers for Premier Foods (LON:PFD), whose household brands span Batchelors and Bisto to Hovis and Hartleys that's been in the press a lot. With £1.1 billion of debt, the company has been under pressure in tough market conditions, indeed its banks have just deferred a covenant test for three months while negotiations continue over longer-term financing. Premier’s recent problems have been numerous but crucially it has been faced with a miserable combination of rising raw materials prices and falling consumer spending. Added to that operational difficulties in some part of its business and a fall out with Tesco over the price of Hovis bread, it is unsurprising that the company’s share price has dived from 35p to 2.8p in the last six months.
So would Altman’s test have flagged the issues at Premier Foods? We’ve calculated the ratios and applied the weightings based on Premier’s last annual results for the 12 months ended December 2010 to see how it stacked up at that time. Let's see if this would have indicated just how serious the issues were, earlier in the year.
Case Study: Premier Foods
First up in the Altman calculation is working capital divided by total assets, which Altman called “T1” and is a measure of asset liquidity. In the case of Premier, this means subtracting £995.8m of current liabilities from £901.1m of current assets to get a net working capital of -£94.7m. Divided by £3.5bn of current assets, this gives a relatively weak T1 value of -0.027.
Next is retained earnings divided by total assets (T2). This measures cumulative profitability over time – such a test discriminates against younger firms (which makes sense since half of all companies fail in their first five years) but it also measures the leverage (high scoring firms typically have financed their assets through retention of profits and not used as much debt). For Premier, this involves taking the company’s retained earnings, which were in the red at -£159.3m, and dividing by that same £3.5bn of assets, which produces a negative score of -0.046.
The next step is T3 (earnings before interest and taxes / total assets), which is ultimately the most important ratio in the equation because it measures profit, which is obviously a major driver in any company’s viability. Altman specifies EBIT and, while this is not quite the same thing as operating profit (because of potential non-operating adjustments), we’ve used Premier’s Operating Earnings of £93.1m for the sake of simplicity. This again is divided by total assets, giving a fairly uninspiring score of 0.027.
The fourth measure is T4 (market cap / total liabilities), which measures how far the company’s assets can decline before it becomes technically insolvent. This involves dividing Premier’s market cap (currently £96.3m) by its total liabilities (£2.51bn) to give a ratio of 0.038. Of course, had we been analysing this earlier in the year, we would have used a higher market capitalisation, but given the difference between market cap and liabilities, it’s unlikely to make much difference in this case.
Finally, there’s T5 (sales / assets), which measures the ability to generate sales. Here, we take Premier’s net sales figure of £2.44bn and divide it by the total assets of £3.5bn to arrive at a score of 0.697.
Ok, now here’s where the magic comes in. Once those ratios have all been calculated, Altman’s “multi-variate” formula adds them together with the different weightings, which range from 0.6 and 3.3 (figures that you then multiply with the score of each ratio to get the result). To be precise, it’s: 1.2*T1 + 1.4*T2 + 3.3*T3 + 0.6*T4 + 1.0*T5.
Doing this for Premier gives a combined Altman Z-Score of 0.713, well below the threshold value of 1.8. This means that a Z-Score calculation at the time of announcement of last year’s reported financials would have placed Premier firmly in what Altman calls the “distress zone”.
Of course, this is just an illustrative example based on last year's financials and it's all very well to be saying this in hindsight. But, for those investors looking to check Altman Z-scores going forward for their portfolio of stocks (and for whom the above calculation just feels too much like hard work!), we’ve now automated the calculation of Altman Z-Scores across the entire market as part of the Stockopedia PRO feature set, so you can easily see at a glance how a company is performing on this basis. Phew! We’ve calculated the scores for all FTSE, AIM and PLUS-listed stocks and found 137 stocks that qualify as being in Altman’s distress zone. Among them, interestingly, are a number of FTSE 250 companies.
It’s worth remembering that the Z-Score is not intended to predict when a firm will file for legal bankruptcy. It is instead a measure of how closely a firm resembles other firms that have filed for bankruptcy, and in doing so it tries to assess the likelihood of economic bankruptcy. Nor is it a crystal ball – it does experience false positives (such as classifying the firm as bankrupt when it does not go bankrupt) in approximately 15-20% of cases. The Altman model has also drawn several statistical objections over the years. It uses unadjusted accounting data; it uses data from relatively small firms and it uses base data that is now 50+ years old. Another possible objection is that the model is a static snapshot based on financials that are updated at most quarterly, if that. As a result, it may not adequately differentiate between firms that were in trouble but are on the mend (as may be the case with Premier Foods given recent newsflow), versus those that are still deteriorating. It is certainly worth applying another tool, the Piotroski F-Score, which we will discuss in another article, to further scrutinise the change in financial health of a stock.
Nevertheless, despite these issues, the original Altman Z-Score model is still the most widely used measure of corporate financial distress, so it seems worth us all paying close attention to, especially in difficult times of global financial stress (sound familiar?).