How to avoid the duffs with the Z-score

Profit warnings in the UK have hittheir highest level since 2009, accordingto accountants Ernst & Young.But will profit warnings translate into bankruptcies? One way to test a company's chances of going under is by using the Altman Z-score. The Z-score, devised by New York-based finance professor Edward Altman in 1968, aims to warn investors which firms are most likely to go bust in the next two years.

Altman took a basket of companies, half of which had filed for bankruptcy and half of which had survived. He then looked at which financial ratios would have most accurately predicted the collapse of those that failed, and combined the best five into a single formula, measuring cash flow, profitability and balance-sheet strength (see below). The formula also takes into account how the market is valuing a company's shares, versus its total debt.

The lower the final score, the higher the chances of bankruptcy: a score above 3 means a company is in good shape, but a score below 1.2 means it could be heading for trouble. In boom times, Altman's scoring system largely gets ignored no one's worrying about bankruptcy.But when markets and growth are stalling (as they are now), it tends to get dusted off. So what is it telling us today?

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Speaking to the CFA Institute earlier this month, Altman noted that in the nearly 50 years since he invented the system, the financial stability of American companies has steadily worsened. There are two reasons for this, he says. Globalisation has increased competition between firms, which has dented individual companies' profitability. Companies have also become increasingly reliant on funding from the bond market as the junk-bond market has grown, meaning that, on average, balance sheets are less healthy now than in the 1960s.

As a result, Altman's so-called "distress zone" has been lowered over time from 1.8 to today's 1.2. Altman also notes that the Z-score should not be applied uniformly across all sectors. It was devised for "nuts-and-bolts" manufacturers, such as Rolls-Royce. Other sectors, such as services or retail, tend to enjoy bigger margins, and so have better Z-scores. The system is also useless for assessing financial groups, like banks, because of balance-sheet complexity.

The most important question is: does it work? In 2008, as markets nose-dived, Morgan Stanley analysts crunched the numbers and found that, while not all companies with low Z-scores are at risk, those that flunk the test are likely to lag the wider market.

What is the Z-score flagging now?

Mining, oil and gas are also firmly in the danger zone, with Anglo American and BP both below 2.0, although silver miner Fresnillo and gold miner Randgold fare much better, at five and 16 respectively. Rolls-Royce, which has announced a string of profit warnings in the last two years, looks relatively healthy on 2.4.

Edward Altman's key ratios

Altman's second most important metric is less conventional:retained earnings divided by total assets. Retained earnings(the sum of the company's profit that has not been paid out individends) is rarely used in other financial ratios, but Altmanargues it is a valuable metric. Older companies that havesurvived previous cycles will have higher retained earningsthan start-ups, he points out. So will companies that havefinanced their own growth, rather than relying on debt.