Posted on 01/09/2024 8:14:35 PM PST by SeekAndFind
When a person wants to get a loan from a bank, they are first evaluated on whether or not they will be able to pay off the loan.
The bank looks at the person’s credit score, and the person either receives the loan or is denied the opportunity.
Most of us have gone through the process once or twice.
But did you know that companies have their own “credit scores” that lenders look at?
Securing additional funds is critical for some companies. And if they can’t, it can eventually result in bankruptcy.
So knowing a company’s financial situation is key to being a good long-term investor.
But you likely don’t have time to sift through pages upon pages of earnings reports and financial statements to diagnose a company’s creditworthiness.
So today, I want to give you another tool for your investing arsenal – one that will allow you to tell whether a company’s finances are stable or whether the company is at risk of bankruptcy.
It’s called the Altman Z-Score, and it’s been a staple of financial analysis for over 50 years.
Here’s the formula for finding the Z-Score…
And here’s what each of the letters represents…
That may sound like a financial word salad. But essentially, we are looking for the value of zeta.
If a company’s Z-Score is above 3, then its finances are in good shape.
A score between 0 and 3 means one should be wary of the company.
And a score below 0 means the company’s finances are in the gutter.
(Note: Originally, anything below 1.8 meant a company’s finances were in distress. Edward Altman, Ph.D. – who developed the Z-Score – recently revised the ranges, which he discussed in a talk in 2019.)
Juggernaut companies Apple (Nasdaq: AAPL) and Microsoft (Nasdaq: MSFT) have Z-Scores of 8.51 and 9.24, respectively.
On the other hand, struggling company Groupon (Nasdaq: GRPN) has a Z-Score of negative 5.39.
Historically, when a company’s Z-Score stays below 0 for a long period of time, it goes on to file for Chapter 11 bankruptcy within a few years.
Toys R Us, for instance, filed for bankruptcy in 2018.
But that wouldn’t have been much of a shock if you had been following its Z-Score, which had been mostly in the distress zone since 2012.
And look what happened with Revlon.
Its Z-Score dipped below 0 and stayed there for over two years before the company finally filed for bankruptcy in June 2022.
Still, some investors bought in, hoping the situation would change.
So how do you avoid making the same mistake?
Fortunately, Z-Scores are public knowledge.
A quick online search of “What is the Z-Score of [company]?” will often generate the results you need.
But the Z-Score is just one tool of many that you should consider when entering into a new trade.
There are plenty of other factors out there that can help you determine whether a company is in distress.
Those include a company’s debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratio, the realized and projected growth of a company’s finances, and many other scoring systems that I plan on covering in the future.
If other indicators suggest that a company is otherwise financially sound, seeing its Z-Score dip below 0 could indicate a good short-term play.
For now, though, I encourage you to use this tool to your advantage.
A quick online search could help you avoid investing in a potentially bankrupt company.
Good investing,
Numbers are only part of it. This seems to deal only with capacity to handle debt. The 5 Cs of Credit:
Charecter
Capacity
Collateral
Capital
Conditions
Just because someone CAN repay a debt doesn’t mean that they WILL.
BTTT for the Z-score profile.
Obviously, you take the highway to the danger zone.
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