How tough are your stocks?

Want to know if a firm is in danger of going bust? Forget the profit and loss account. Companies can look as though they are generating decent profits on paper, almost right up until the point they file for bankruptcy. If you want to test financial strength, you need to look at the balance sheet.

Indeed, Sir David Tweedie, the ex-head of the International Accounting Standards Board, reckons this is the most important financial statement for any investor to look at. But what are you looking for? There are two straightforward tests you can use to determine how sound a company's finances are. One is the Altman Z score, the other the Piotrosksi score. Here's how they work.

The Altman Z score

Edward Altman is a professor of finance at New York's Stern School. His Z score measures the likelihood of a firm going bust. It takes five ratios that use numbers from a firm's balance sheet, plus a few from the profit and loss account. Each ratio is then weighted to reflect its relative importance, before the five are combined to generate a Z score, usually a single-digit figure. So what are the five ratios?

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1. Operating profit' or EBIT (earnings before interest and tax) to total assets: This is the most important component of the Z score and so gets the highest weighting. This ratio reveals how effectively a company makes money from its assets. A more efficient company will tend to weather hard times better than one that employs its assets wastefully.

2. Retained earnings to total assets: This indicates the cumulative profitability of the firm compared to its size. Shrinking profitability is a warning sign. This measure can also show whether a firm is being financed heavily by debt rather than its past profits.

3. Working capital to total assets: This compares short-term liquid assets such as cash and receivables (working capital) to the total long (fixed) and short-term (current) assets from the balance sheet. A firm in trouble will often suffer shrinking liquidity and a low ratio. Because working capital includes cash, this ratio can be an early warning sign of cash flow trouble.

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4. Sales to total assets: This is a snapshot of how effectively a firm uses its assets to generate sales as opposed to earnings (see ratio 1). The lower the ratio, the less efficient the firm, and the more exposed it is to a slump. This is given a lower weighting than the first ratio because ultimately a firm must make profitable sales, not just any old sales. Note that when comparing non-manufacturing firms, this ratio is often left out (and the remaining four reweighted) to account for the fact that they tend to be less capital intensive.

5. Market capitalisation (or equity value) to total liabilities: This offers a quick test of how far the company's assets can decline before its liabilities exceed its assets and it risks becoming insolvent. The lower the ratio, the bigger the risk. Calculating all five ratios then weighting them is quite a challenge. So it's faster to get the figures you need from the acounts, and then use an online Z score calculator, such as Creditguru.com.

Interpreting the Z score

The lower the Z score, the higher the risk. Any firm scoring more than three is considered to be relatively healthy. In the current uncertain climate I would be wary of a result below three, even if some commentators describe it as a "grey area". And any firm scoring 1.8 or less on Altman would generally be considered to be in financial distress.

Do note, however, that the original model was not designed for financial firms such as banks largely because their balance sheets are rather different to those of non-financial firms.

The Piotroski score

Devised by an accounting professor at the University of Chicago, this uses nine tests to rate a stock, primarily using balance-sheet criteria, backed up with cash flow and earnings strength. The score for each test is simple: a firm gets one if it passes, or zero if it fails, for a total score of between zero and nine. Anything above seven is considered solid by the global strategy team at JP Morgan.

The tests are largely self-explanatory. You want to see positive net income; positive cash flow; operating cash flow above net income (a test of the quality of reported income); a lower ratio of debt to total assets than the year before (ie, falling gearing); increased working capital (or net current assets on a balance sheet this suggests liquidity is improving); higher asset turnover (sales/total assets is an indicator of efficiency as with the Altman Z score); a higher return on assets than the previous year; the same or fewer shares outstanding on a year ago (companies that have to keep asking their shareholders for more equity are often in trouble); and rising profit margins.

One big caveat

While these two scores can give you an idea of how sound a stock is, neither will tell you whether a firm is good value at its current share price. For that you'll need other ratios such as the price/earnings(p/e). However, both can save you from weak stocks that deliver nasty shocks.

This article was originally published in MoneyWeek magazine issue number 588 on 11 May 2012, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.