At the end of 1999, Enron -- soon to be the poster-child for corporate fraud and bankruptcy -- carried a solid investment-grade credit rating of 'BBB,' indicating a company with solid footing to meet its obligations.

Fast-forward to June 2001, just months before Enron's historic collapse. Enron's share price had already been cut nearly in half over the prior six months, but credit ratings agencies still rated Enron 'BBB.' Unfortunately, many investors still held out hope that the problems brewing with the company were temporary and the shares would recover.

But there was one metric that forecasted a completely different outcome: the Z-score.

While many investors hoped of a comeback -- pointing to the company's still solid rating, the Z-score foretold a different story. Enron's Z-score coincided with a company that should have a rating of 'B' -- barely above junk status.

In fact, ratings agencies had Enron listed at 'BBB' until four days before it filed for bankruptcy. But those who paid attention to the Z-score were way ahead of Enron's collapse.

What's Behind the Metric That Forecasted Enron's Fall

The Z-score, also known as the Altman Z-score, was developed in the 1960's by NYU professor Edward Altman. Altman used statistical analysis to determine which financial ratios were the best predictors of a company's vulnerability to bankruptcy. He then put together a model that optimized the predictive value of those ratios. The result is one nice, neat number that contains a lot of forecasting power.

Over time, the Z-score has proved to be one of the most reliable predictors of bankruptcy. In a series of tests covering 316 distressed companies from three time periods between 1969 and 1999, Altman and his Z-score were between 82% and 94% accurate in predicting future bankruptcies.

In general, the lower a company's Z-score, the higher the chance of bankruptcy. The rule of thumb is that for a manufacturing company, a Z-score above 3.0 indicates financial soundness, but a score below 1.8 suggests a high likelihood of bankruptcy.

So what's behind this highly useful metric?

3 Easy Steps to Calculate the Z-score

To calculate a manufacturer's Z-score from scratch, the first step is to identify the seven items listed on the balance sheet and income statement used in the calculation:

Z Score Exhibit 2(1)

Together, these seven figures are used to create five financial ratios, each identified by Altman as having the greatest forecasting power as to a company's financial strength:

Z Score Exhibit 3(1)

The third and final step is to use these ratios in the Z-score formula to create the final value:

Z-score = 1.2*(A) + 1.4*(B) + 3.3*(C) + 0.6*(D) + 1.0*(E)

As mentioned earlier, the rule of thumb is that a Z-score above 3.0 indicates financial soundness, but a score below 1.8 suggests a high likelihood of bankruptcy.

Non-Manufacturer's Z-score Equation

But what about companies not in the manufacturing arena? Altman's original equation was focused on manufacturing firms, but he eventually devised additional equations to deal with non-manufacturers and privately held firms.

The Z-score formula for non-manufacturers is just a little bit different from the original. As before, you identify the following seven items (a few are different) listed on the balance sheet and income statement:

Z Score Exhibit 4(1)

Then, combine and re-combine them into four financial ratios:

Z Score Exhibit 5(1)

Finally, use the Z-score formula for non-manufacturers:

Z-score = 6.56*(A) + 3.26*(B) + 6.72*(C) + 1.05*(D)

In this case, a Z-score above 2.6 indicates financial health, while anything below 1.1 indicates distress.

Why Does the Z-score Work?

By now, you should have an understanding of how the Z-score works -- simply follow the formula to arrive at the calculation. But what you may not understand it why the formula has been so accurate in predicting corporate bankruptcies.

It turns out that the Z-score contains a pretty comprehensive summary of a firm's financial health. Consider the following ratios, each of which are used in the score's calculation:

- Ratio A, Working Capital / Total Assets, is a liquidity measure. Working capital is comprised of cash and any other assets that can be turned into cash on fairly short notice. The more working capital a firm has, the more cushion it has to meet any bills coming due.

- Ratio B, Retained Earnings / Total Assets, is a measure of leverage. It tells us whether the firm is paying for assets using profits or using debt. A high ratio indicates that profits are being used to fund growth, while a low ratio indicates that growth is being financed through increasing debt levels.

- Ratio C, EBIT / Total Assets, is a profitability measure also known as return on assets (ROA). It measures the amount of operating income generated by each dollar of assets.

- Ratio D, Market Cap / Total Liabilities, is a measure of the market's confidence in the company as reflected in its stock price. If the ratio falls below 1.0, then the market is saying that the firm is worth less than what it owes, or in other words, insolvent.

- Ratio E, Sales / Total Assets, is a measure of efficiency in that it describes the amount of sales generated by each dollar of assets.

It should now be easier to see why the Z-score is such a good measure of a firm's financial health. A healthy firm (A) maintains enough liquid assets to pay whatever bills are due, (B) funds its growth with profits, (C) invests in assets that generate profits for its owners, (D) gets a vote of confidence from investors via its share price, and (E) converts its investments into revenues for the company.

Screening for Ticking Time Bombs

Now that you understand the power behind the Z-score, you might be wondering if there are any companies whose scores indicate trouble on the horizon. In fact, there are several.

If you're interested in seeing a list of companies with low Z-scores, your best bet is to use a stock screener. There is a handy (and free) screener available at that includes a Z-score parameter. We used the ADVFN screener to search for U.S.-based manufacturing companies listed on the S&P 500 with a market capitalization of over $4 billion and a Z-score of under 1.8. Here are the results (as of April 12, 2010):

Z Score Exhibit 1(2)

While it's not surprising to see a homebuilder like Pulte (NYSE: PHM) on the list, it may not have been obvious that firms like General Electric (NYSE: GE), Caterpillar (NYSE: CAT) and Harley-Davidson (NYSE: HOG) look vulnerable, too.

Remember, just because a firm carries a Z-score below 1.8 doesn't mean bankruptcy is a foregone conclusion. Given the recession, it's not surprising to see many firms on the list that under normal circumstances wouldn't be shown.

It's also important to keep in mind that many firms do bounce back from tough financial circumstances. And like all stock screener results, the list of companies should be seen as a starting point for additional analysis, not an instant buy/sell recommendation.