How to spot if a company is in trouble

Good investors try to keep their risks low, and one of the biggest risks you can take is to invest in a company with dodgy finances. So how can you avoid the financial basket cases? One option is to use the Altman Z-Score.

Back in the late 1960s, Edward Altman, a professor of finance at New York University, set about finding a way to predict which companies were heading for bankruptcy. He studied lots of non-financial companies and crunched 22 different financial ratios with numbers taken from the companies' accounts.

What he came up with was a formula that has proven to be a very good predictor of future financial distress. It's called the Z-Score. The score is based on five particularly useful financial ratios that Altman labelled X1 to X5.

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The Z-score is calculated by adding the ratios together, with some getting a higher weighting in the equation than others.

You can see a worked example comparing two companies in the box below, but for now, let's look at the individual ratios and what they measure.

X1: Working capital/total assets

Working capital is the difference between a company's current assets (things that can be turned into cash within one year) and current liabilities (bills or debts that have to be paid within a year). It's not a good sign if a company only has a small amount of working capital, or even worse, negative working capital.

X2: Retained profits/total assets

Retained profits are a company's cumulative profits that have not beenpaid out to shareholders over its life. Small retained profits are found inweak or young companies, whichare more likely to fail.

Companieswith high retained profits compared to total assets tend to have financed their business with profits rather than relying on lots of debt a good sign, accordingto Altman.

X3: Trading profits/total assets

This shows how productive a company is. Good, strong companies make big profits in relation to their assets. Weak ones do not. Altman found this was a particularly good predictor of bankruptcy, and gave it a high weighting in his Z-score equation.

X4: Market value of equity/total liabilities

This measure shows how far a company's assets can fall in value (measured by the market value of equity plus debt) before the assets are less than its liabilities and the company is insolvent. So a company with equity valued at £1,000 and debt of £500 (a total market value of £1,500) could see its assets fall by two-thirds before it was insolvent.

X5: Sales/total assets

The ability of the firm's assets to generate sales the lifeblood of any company.

Strong firms would have a Z-Score of three or more. A company with a Z-Score of less than 1.8 is seen as having problems and could be heading for bankruptcy. It's fairly easy to work out a company's Z-Score as all the numbers needed can be found in its financial statements, while market values can be found in newspapers or online. The box below shows an example of a strong and a weak company.

A worked example

Reckitt Benckiser (LSE: RB) has strong finances thanks to its very high profitability. Look at the 2013 accounts for Premier Foods (LSE: PFD), on the other hand, and the company is clearly in a bad way.

Years of losses and poor profitability, along with plenty of debt, have caused it no end of problems. This explains why earlier this year it had to ask its shareholders for more money.

Other things to look for

The Z-Score does a good job in identifying companies that could get into financial difficulties, but it pays to look at other measures too. Interest cover is an especially useful metric.

It looks at whether profits are large enough to meet the interest bill on any debt. It's also worth looking at how variable profits have been over a long period say ten years. You should also look for hidden liabilities, such as rental payments on buildings.

Don't ignore a company's cash flow either. Calculating a company's free cash flow as a percentage of its outstanding debt will give you an idea of how long it could take the company to pay off its debts.