1. The common way is to look at the credit ratings given by rating agencies, who, however, give different ratings for specific debt instruments, and not for the company itself.
2. The best strategy for retail investors is to follow a system that looks at the overall rating of the company, and calculating the Altman's Z score is one such method which was originally devised in the 60's to warn investors about firms likely to land in financial trouble or likely to face bankruptcy in the next two years.
3. For arriving at a company's Altman's Z score, publicly available information like working capital, total assets, total liabilities, current assets, current liabilities, net sales, earnings before interest and taxes (EBIT), retained earnings and market cap, are used to calculate the following ratios first:-
a) EBIT/total assets:- This is also called the return on total assets and explains how effectively the company is using its assets to generate earnings before contractual obligations are paid.
b) Retained earnings/total assets:- This is the portion of profit kept aside by a firm over the years, where high retained earnings to total assets ratio represents a company's ability to fund part of its growth without resorting to debt.
c) Working capital/total assets:- Working capital, i.e. current assets minus current liabilities, will be positive if the current assets are more than the liabilities, and the percentage of assets required to run the day-to-day operations helps analyse the assets tied up in working capital.
d) Net sales/total assets:- This is also called the total assets turnover ratio and represents how effectively the company is using its assets to generate revenues.
e) Market cap/total liabilities:- This is a modified version of debt/equity ratio and shows how stock price fluctuation can alter the prospects of indebted companies.
4. Finally the Altman's Z score is calculated as:-
(EBIT / total assets x 3.3) + (Retained earnings / total assets x 1.4) +
Working capital / total assets x 1.2) + (Net sales / total assets x 0.9) + (Market capitalisation / total liabilities x 0.6).
5. The higher the value, the lower is the chance of financial trouble, and as per the standard analysis, a score above 3 indicates that financial trouble is unlikely, and a score below 1.8 indicates that financial trouble is possible within two years.
2. The best strategy for retail investors is to follow a system that looks at the overall rating of the company, and calculating the Altman's Z score is one such method which was originally devised in the 60's to warn investors about firms likely to land in financial trouble or likely to face bankruptcy in the next two years.
3. For arriving at a company's Altman's Z score, publicly available information like working capital, total assets, total liabilities, current assets, current liabilities, net sales, earnings before interest and taxes (EBIT), retained earnings and market cap, are used to calculate the following ratios first:-
a) EBIT/total assets:- This is also called the return on total assets and explains how effectively the company is using its assets to generate earnings before contractual obligations are paid.
b) Retained earnings/total assets:- This is the portion of profit kept aside by a firm over the years, where high retained earnings to total assets ratio represents a company's ability to fund part of its growth without resorting to debt.
c) Working capital/total assets:- Working capital, i.e. current assets minus current liabilities, will be positive if the current assets are more than the liabilities, and the percentage of assets required to run the day-to-day operations helps analyse the assets tied up in working capital.
d) Net sales/total assets:- This is also called the total assets turnover ratio and represents how effectively the company is using its assets to generate revenues.
e) Market cap/total liabilities:- This is a modified version of debt/equity ratio and shows how stock price fluctuation can alter the prospects of indebted companies.
4. Finally the Altman's Z score is calculated as:-
(EBIT / total assets x 3.3) + (Retained earnings / total assets x 1.4) +
Working capital / total assets x 1.2) + (Net sales / total assets x 0.9) + (Market capitalisation / total liabilities x 0.6).
5. The higher the value, the lower is the chance of financial trouble, and as per the standard analysis, a score above 3 indicates that financial trouble is unlikely, and a score below 1.8 indicates that financial trouble is possible within two years.