In 2009, Morgan Stanley (NYSE:MS) strategy analyst, Graham Secker, used the Z-score to rank a basket of European companies. He found that the companies with weaker balance sheets underperformed the market more than two-thirds of the time. Other studies have found similar results.
The takeaway? Screen out weak balance sheets.
One effective way to do this is to apply the Altman Z-Score, a checklist that was found to be up to 80-90% accurate in predicting bankruptcy one year before the event in the 31 years up until 1999 in the original study.
A Z-Score of more than 2.99 is considered to be a safe company, but a Z-Score of less than 1.8 points to a significant risk of financial distress within two years. We can see the checklist in action by applying it to a listed company. Take large cap UK grocer Tesco (LON:TSCO), for example.
The group's shares have taken off as its turnaround strategy bears fruit, but how does Tesco fare against Altman’s influential checklist?
What does the Altman Z-Score flag up about Tesco?
Unfortunately, Tesco fails Altman’s test, with a worryingly low Z-Score of 0.58...
Tesco's low Z-Score doesn't mean that it is definitely heading for financial distress, but it does mean this fate is more of a risk for Tesco than it is for most.
Disclaimer: These articles are provided for information purposes only. The content is not intended to be a personal recommendation. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser. The author has no position in the stocks mentioned, unless otherwise stated.