In 2009, Morgan Stanley 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 style neutral Tesco (LON:TSCO), for example.
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 0.31... 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 the group than it is for most.
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