Bankruptcy Detector: Analyst's Toolkit

BOSTON (TheStreet) -- Bankruptcy is a vile word to equity investors. It's the worst-case scenario because investors may get wiped out as companies pay back higher-priority creditors first.

During difficult economic times like these, bankruptcies skyrocket, making it even more important for investors to pick shares of companies with a solid financial footing.

But it's not easy to pick sick puppies, since net losses or massive debt loads by themselves may not have much bearing on a company's survival. To help address that, New York University professor Edward Altman developed a model known as the Altman Z-Score to determine the relative risk of a particular company filing for bankruptcy within two years.

The formula looks more like a regression equation than a straight financial ratio, with weightings being applied to the ratios used to predict potential insolvency. The track record for the model since its birth in 1968 has been impressive. While no model will be infallible due to the random events that affect the fate of companies, the Altman Z-Score's accuracy is as much as 90%.

The model can be stated as follows:

Z = 1.2W + 1.4R + 3.3E + .6M + 1S.

Where: W = Working Capital / Tangible Assets; R = Retained Earnings / Tangible Assets; E = EBIT / Tangible Assets; M = Market Value of Equity / Total Liabilities; and S = Sales / Tangible Assets. (Note: Total Assets can be used in place of Tangible Assets to simplify the calculation.)