How likely is a company to go bankrupt? This is a difficult question to answer, but there is a relatively simple calculation one can do to size up the strength of a company's financial situation. The Altman z-score was introduced in 1968 and is a simple sum of five components derived from a company's balance sheet and income statement. The result of this calculation, the z-score, is a measure of the risk of bankruptcy.
If this number is above 2.99 then the company is considered safe. Between 1.81 and 2.99 is the "grey zone," where the company is not in immediate danger of bankruptcy but may be heading in that direction. Anything below 1.81 means that the company is distressed and has a good chance of going bankrupt within a few years.
These weightings and limits are completely empirical, not based on anything fundamental — they're simply what works. The model has been extremely accurate in predicting bankruptcies, with a success rate around 80% to 90% according to a research. It's not perfect, but it is a helpful gauge of financial stability.
Three Cases
I'll use the Altman z-score to determine to financial stability of three companies which are widely believed to be in trouble. It's helpful to do the calculation for the past few years to see how the z-score has changed, so I'll include the results from 2008 through 2012.
Advanced Micro Devices (AMD, Financial)
AMD has seen better days. A perpetual second string to Intel in the PC and server market, AMD has no real footing in the mobile market and saw sales fall hard in 2012. One nugget of good news for AMD is that its processors appear in the Playstation 4 from Sony and the XBox One from Microsoft.
For the past five years AMD's z-score has been in the distressed region. The financial crisis caused a lot of companies to have problems, and during 2008 the z-score went negative. It began to improve through 2010, but has since turned around and become negative again. According to this, AMD is in as bad a shape as it was during the financial crisis. Not a good sign for the company.
The biggest negative component for AMD is the retained earnings / total assets, or B. Since retained earnings are becoming more and more negative this means that AMD is increasingly funding its operations through the use of debt as time goes on. Indeed, AMD has about $2 billion in debt, a number which increased from 2011. Its cash balance sits at about $1 billion, but this has fallen considerably over the last few years. With a negative free cash flow of $471 million in 2012 and annual interest payments of $175 million, it won't be long before the company blows through all of its cash. AMD is at risk of becoming just a memory within a few years' time.
After a hyped-up IPO, Groupon has seen its stock price fall from $26 per share to right around $5.50 per share, hitting a low of $2.60 at one point last year. This decline comes as people have begun to question the sustainability of Groupon's business model. Is Groupon in danger of bankruptcy, or does the company have time to right the ship?
Since Groupon held its IPO in 2011, the data only goes back that far. The z-score was in safe territory after 2011 but has since fallen into the "grey zone." The company doesn't actually have any debt, so it's impossible to go bankrupt right now. The component responsible for most of the drop is the market cap / total liabilities, or D. This is the only component which relies on something not directly from the financial statements, so I would argue that this z-score decline is less meaningful than if a different component were the driver. Given this, I don't think Groupon is in danger of bankruptcy anytime soon, although long term is anyone's guess.
RadioShack is struggling to remain relevant as it has shifted to mainly selling mobile devices and the associated mobile plans. Revenue has been declining since 2010 and in 2012 both net income and free cash flow turned negative. People have become extremely pessimistic regarding the company, and the stock price fell from $20 per share in 2009 to a low of $1.90 per share last year. For a time the company was actually selling for less than its current assets minus total liabilities. Is this pessimism warranted?
RadioShack is actually in the best shape of all three companies. While the z-score has been declining it is still within the "safe zone." Like Groupon, the stock price falling so much has a lot to do with the decline rather than a deterioration of the financials. RadioShack does have $778 million in debt and only $536 million in cash, and interest payments total $55 million per year. Obviously, if RadioShack continues to lose money year after year the z-score will decline further and bankruptcy will become a real risk. But as of right now the company looks fine, and it could easily survive five years or so losing as much as it lost in 2012 before bankruptcy became a real possibility.
The Bottom Line
While the Altman z-score is not perfect it does provide a simple way to check on a company's financial situation. AMD is clearly in serious trouble, with a negative z-score and big losses in 2012. Groupon, although its business model may not be strong in the long term, has very little chance of going bankrupt any time soon. And RadioShack has at least a few years to turn things around before its financial situation catches up with it.
