Business distress and bankruptcy can put a dent in your portfolio no matter how well diversified you are.
That's why paying attention to simple checklists that flag up risky stocks is so important. Stockopedia provides many of these screening tools to help investors safely navigate the stock markets. One of them - the Altman Z-Score, which was developed by New York University finance professor and leading academic, Edward I. Altman.
It measures how closely a firm resembles other firms that have filed for bankruptcy by considering the following areas:
- Current assets as a proportion of total assets,
- Cumulative profitability and use of leverage,
- Productivity of assets, and
- Firm value compared to liabilities
A Z-Score of more than 2.99 is considered to be a safe company. Those with a Z-Score of less than 1.8, on the other hand, have been shown to have a significant risk of financial distress within two years. We can see the checklist in action by applying it to a listed company. Take mid cap value trap Tullow Oil (LON:TLW), for example.
How does Tullow Oil fare against Altman’s influential checklist?
What does the Altman Z-Score flag up about Tullow Oil?
Tullow Oil's Altman Z-Score of 1.63 is an amber flag, suggesting caution is needed when considering this company. This 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 Tullow Oil than it is for most.
Specifically, our algorithms flag two risks:
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. This quick look at Tullow Oil shows that it also has weak spots that require further investigation.
Fortify your portfolio with simple, effective tools
The problem areas for Tullow Oil identified here can be explored in more depth on Stockopedia's research platform. All the best investors have stringent due diligence processes that reduce the chances of them suffering big losses, so why not take a leaf out of their book?
Simple tools can help us better measure and understand the risks we take. That's why the Stockopedia team has been busy building new ways of understanding investment risks and company characteristics. In this webinar, we talk about two or our most popular innovations: StockRank Styles and RiskRatings. These indicators transform a ton of vital financial information into intuitive classifications, allowing you to get an instant feel for any company on any market - sign up for a free trial to see how your stocks stack up.