To protect your capital, you need to know how to see warning signs of troubled businesses before they go off a cliff -- and take your portfolio with them. For years, experts have used one fairly simple measure to predict corporate bankruptcies -- and it's had a pretty good success rate.

Over 40 years ago, NYU business professor Edward Altman came up with a model for predicting what companies might fall into bankruptcy. Known as Altman's Z-score, the measure gives you a way to evaluate stocks that may be in danger of becoming insolvent.

Focusing on financials
The Z-score calculation depends entirely on figures you can obtain from a company's quarterly financial reports. The model takes into account five different variables that incorporate seven data points from company balance sheets and income statements:

  • The ratio of working capital to total assets gives you a sense of how much liquidity a company has to run its daily operations.
  • The ratio of retained earnings to total assets tells about the company's past earnings history and how much money a company has put back into its business.
  • The ratio of operating earnings to total assets shows how profitable a company is, factoring out interest and taxes, which can mask long-term viability.
  • The ratio of market capitalization to total liabilities describes how big a factor debt is within a company.
  • The ratio of sales to total assets gives a sense of how quickly a business turns over the goods or services it produces from the capital it owns.

As you can see, with all of these components, the higher the ratio, the healthier the business. To calculate the Z-score, you take each ratio and multiply it by a factor as listed below:

Ratio

Multiplier

Working capital to total assets

1.2

Retained earnings to total assets

1.4

Operating earnings to total assets

3.3

Market cap to total liabilities

0.6

Sales to total assets

1.0

Add up each product and you have the Z-score. Commonly, a score below 1.8 is seen as indicating a strong danger of bankruptcy, while a score above 3 is considered relatively safe.

Far from perfect
The Z-score has performed well. One study indicated that the measure has a success rate of roughly 72%.

Still, that's far from 100%, so although it's a useful conceptual tool, you clearly can't rely on the Z-score as a perfect predictor. Over the years, plenty of businesses with dangerously low Z-scores have come back from the brink, producing extremely attractive performance. Look, for instance, at these companies that were in dire straits back in 2003, following the end of the tech bust:

Stock

Z-Score 2003

Current Z-Score

6-Year Average Annualized Return

Priceline.com (NASDAQ:PCLN)

0.1

3.1

43.9%

Foster Wheeler (NASDAQ:FWLT)

1.1

3.3

10.2%

Titanium Metals (NYSE:TIE)

1.2

5.9

61.2%

Clean Harbors (NYSE:CLH)

1.2

3.7

26.5%

Fuel Systems Solutions
 (NASDAQ:FSYS)

1.5

4.3

25%

Terra Industries (NYSE:TRA)

1.3

3.9

57.9%

ABB (NYSE:ABB)

1.2

3.2

39.5%

Source: Capital IQ, a division of Standard and Poor's.

Investors clearly believe the Z-score works, because shares tend to fall to very low levels when Z-scores are low. For those companies that survive, though, those low prices mean big gains for investors who stay the course.

Avoiding the gamble
Despite the fact that the Z-score isn't perfect, many investors feel far more comfortable steering clear of any sign of potential bankruptcy. And while this method won't pick up bankruptcies caused by factors other than those that show up on the balance sheet -- factors like unexpected business disruptions -- it's worth adding to your toolbox of ways to size up your prospective investments.

For more on investing in a tough market: