Apart from earnings, you also need to look at the financial health of the company, especially if you are a long-term investor. It is better to bet on companies with a healthy balance sheet. However, debt accumulation is a part and parcel of every business. Thus it is difficult to determine the financial health of a business just by comparing its debt figures.
Here are three things to know:
In 1968, Edward I. Altman, an assistant professor of finance at New York University, came up with a formula to predict the probability of a firm's bankruptcy in two years. Since then, analysts have used the formula to measure the financial distress of a company and the chances of its default.
It is calculated using the company's liquid assets, profitability, earning power, operating efficiency, its liabilities, total sales, and assets. It also takes into account the fluctuation in its share price. However, this is only applicable for non-financial companies.
If the formula is applied to companies in developing economies, a major chunk of them would be classified under the 'distressed' category. This is because a lot of companies, predominantly those that are service-oriented, have low physical assets. This affects the total score. Hence, there is a modified formula which takes into account only earnings before interest and taxes, working capital, profitability, liabilities and market capitalisation. It does not factor in total sales.
The modified Z-score is often in single digits. The higher the score over 3.75, the greater is the stability in the balance sheet. Those between 1.75 and 3.75 are in the grey zone, while those with a score lower than 1.75 are distressed. Unsurprisingly, stocks of such companies underperform those in the safe zone over a longer period.
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