How Z scores can help you beat the slump

Before the credit crunch struck, corporate solvency was the last thing on investors' minds. Cash was easy to come by and consumers were spending freely. Times have changed. Profit warnings in the UK are now at their highest quarterly level since 2001, according to accountancy firm Ernst & Young. Spain has just delivered what Morgan Stanley's Graham Secker describes as Europe's "first large-cap failure in this cycle" with the collapse of property developer Martinsa-Fadesa.

This means that out-of-favour investment measures, such as Edward Altman's Z scores, are being dusted down. The system was originally devised back in the 1960s to warn investors about firms at risk of going bust but it can also help you find the sectors and stocks best able to withstand the crunch. Secker claims that when the Z score is applied across the European market it shows that some sectors contain corporate balance sheets "at their strongest for 20 years" exactly the sorts of stocks that should benefit during the hard times ahead.

How Z scores work

Altman's model is based on analysing the financial strength of a company using five ratios built on key numbers mainly taken from a firm's balance sheet, along with a few from the profit and loss account. Each ratio is then weighted to reflect its relative importance before the five are added together to generate a Z score, usually a single digit figure. Here's how it works, using figures drawn from the income statement and balance sheet of Vodafone's 2008 accounts. The ratios are listed in order of importance.

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EBIT to total assets

This is the most heavily weighted in other words, the most important component of the Z score. EBIT is earnings before interest and tax, or "operating profit". This ratio shows how productive a company is in earnings terms, relative to its size. Basically, it demonstrates how much value for money a firm is getting from its assets. More efficient companies tend to be better placed to thrive during hard times. In Vodafone's case, the relevant figures are the operating profit of £10,047m and total long- and short-term assets, which add up to £127,270m.

Retained earnings to total assets

This indicates the cumulative profitability of the firm, again compared to its overall size. Shrinking profitability is obviously a warning sign. This measure can also indicate how highly geared a company is. As Secker points out, high retained profits suggest that a firm may have financed its assets through profits rather than debt. Vodafone doesn't have any retained profits; rather it has £81,980m of retained losses.

Working capital to total assets

This compares liquid assets, called "working capital" or "net current assets", to the total long ("fixed") and short-term ("current") assets from the balance sheet. A firm in trouble will usually experience shrinking liquidity by this measure. In other words, as sales fall or costs rise, the amount of easily available cash will fall. Vodafone's balance sheet at 31 March 2008 shows current assets of £8,724m, minus current liabilities of £21,973m, giving working capital of £13,249m.

Sales to total assets

This is a measure of how effectively the firm uses its assets to generate sales. This uses the turnover figure at the top of the profit and loss statement for Vodafone this is £35,478m.

Market cap to total liabilities

This offers a quick test of how far the company's assets can decline before the firm becomes technically insolvent the point at which its liabilities exceed its assets. For Vodafone, the market cap on 4 August, according to Digitallook.com, was £72.18bn, while total liabilities (that's the short and long-term liabilities combined) come to £50,799m. You could calculate all of these ratios and then weight them by hand. But it's faster to get the relevant figures from the balance sheet and profit and loss, then feed them into an online Z score calculator, such as the one at Creditguru.com/CalcAltZ.shtml. Using the figures from the example above gives Vodafone a Z-score of 0.364.

What does it all mean?

In short, avoid Vodafone for now. The weaker the Altman score, in particular a reading around or below about 1.6, the greater the chance of a firm suffering financial distress within the next two years. While no one is suggesting Vodafone is about to go bust, Secker points out that firms with a Z score of below one have always tended to underperform the market, "particularly in recessionary periods". Taking the period from 1990 to 2007, the average compound annual growth rate (CAGR) for these stocks was 3.3% against 4.1% for the median stock in the market.

Vodafone is not alone

So which sectors should you avoid and which could be set to do well? Looking at European markets, based on Z scores, several apparently defensive sectors should be avoided altogether, including telecoms services (2007 score 1.90) and utilities (1.91). Other sectors to be wary of include transportation (1.67), capital goods (1.67) and anything to do with cars (1.49) as Ford and GM shareholders no doubt already know.

But it's not all doom and gloom. Low-scoring stocks can do well but only once the economy is recovering. That seems a distant prospect, so a much better bet is to seek out stocks from sectors with high Altman scores. Between 1990 and 2007, Secker notes that those scoring between 2.5 and 3 provided a CAGR of 6.3%. The top five sectors by Z score ranking are household and personal products (2007 score 5.5); semiconductors (5.47); health care (3.63); commercial services (3.61); and technology hardware (3.48).