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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.

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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.)

The output from this formula will be a seemingly random number that only has value when applied against the following scale:

  • Z is greater than 3.0: Safe Zone (little risk of bankruptcy).
  • Z is from 1.8 to 3.0: Inconclusive "Gray" Zone (potential for bankruptcy heightened).
  • Z is less than 1.8: Distress Zone (bankruptcy a strong possibility).

The scores produced by the formula are ordinal but non-linear, meaning that while a company that has a score of 4 is safer than a company with a 2, it's not twice as safe. It's also far more important to look at the progression of scores over several quarters since a one-time dip won't be nearly as troublesome as a streak of poor performance. Z-Scores are also impractical for financial companies since so much of the operations may be obscured in off-balance-sheet accounting schemes.

Applying the Z-Score to companies that are the picture of health and those that have been much maligned recently can help illustrate the model's output and the clear disparity between those companies that have a bright future and those that will have a tough road ahead.

Wal-Mart(WMT Quote) and Apple(AAPL Quote) are some of the clear winners, according to the Altman Z-Score. Wal-Mart gets a 4.79 and has stayed in a range of 4.5 to 5 for the past three years, indicating a stable financial situation. Apple is in a similar position, with a score of 4.67 and a history of 8-plus readings, leading to little reason to worry for shareholders.

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The have-nots are far more varied. Rite-Aid(RAD Quote), a company that many see as teetering on the edge of solvency, has only recently fallen below 3 and currently has a score of 2.6, suggesting that while it is not a strong company, it's not in the danger zone quite yet.

Macy's(M Quote) has had similar concerns, yet it too falls in the gray zone. A score of 1.8, its first below 2.5 since 2006, is certainly on the low end of the range bordering trouble, but it doesn't suggest imminent danger.

A company that has more to worry about is Hertz(HTZ Quote). Its score of 0.5 is actually an improvement since it had spent all of 2008 in negative territory. Investors should be wary of the rental-car giant as the Z-Score is predicting bad things.

Sirius XM Radio(SIRI Quote) already nearly collapsed in February, saved by an investment from Liberty Media, which would have proved the Altman model correct as Sirius has had a negative Z-Score since 2006. Sirius currently has a shockingly bad Z-Score of minus 15.4, suggesting the Sirius Dog has left a steaming pile of trouble on the balance sheet.

While bankruptcy isn't a fait accompli, one thing that is certain is Sirius' legions of fans will spring to its defense with conspiracy theories and pledges of allegiance to "Mel," referring to Chief Executive Officer Mel Karmazin.

The Altman Z-Score has been a standard in financial analysis for more than 40 years. Consider using this measure in your analysis to help pick the wheat from the chaff.

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