There are rumours, and factual reports of defaults, and likely liquidity issues in multiple sectors. Bank lending to the NBFC sector is now constrained by fears. The effect on stockmarket values is obvious.
A rough calculation suggests that 20 per cent of all listed companies are trading below their respective face values. That’s a lot higher than the historical ratio of about 15 per cent. The policy response is likely to be a combination of rate cuts and other liquidity-enhancing measures.
A combination of low profits and high tax rates could lead to further problems with debt-servicing. In this situation, a long-term investor must seek to identify and avoid corporates with likely future debt-servicing problems.
There are many different methods for analysing a balance sheet for debt-servicing ability. One of the best, and easiest, is the Altman Z Score. This is a weighted set of five balance sheet ratios created by Professor Edward Altman of the Stern School, NYU.
Altman’s ratios were A) Working Capital/ Assets, B) Retained earnings/ Assets, C) EBITDA/Assets, D) Market Cap/Total Liabilities and E) Sales/ Assets. His suggested weights were Ax1.2+1.4B+ 3.3C+ 0.6D and 1E. The higher the score, the stronger the balance sheet. A cumulative score of 3-plus is safe, while a score of less than 1.8 is considered dangerously close to bankruptcy. As a further refinement, Altman’s Z Score Plus methodology compares Z-score to credit ratings.
As the weights of the Z-Score indicate, profitability is considered to be the key factor for financial health. High retained earnings (equating to higher reserves) is the second-most important factor. A drop in earnings before interest, tax, depreciation and amortisation (EBITDA) means a sharp deterioration in the Z-Score, and lower profits leads to lower retained earnings.
The past three quarters has seen falls in profitability across most sectors. Under the circumstances, defaults are more likely and it’s not surpriing that the financial crisis has brewed up. If we go by Z-Scores, a lot of corporates have slid closer to the bankruptcy zone. Any investments made now need to pass the Z-Score test.
Another interesting metric is the C-Score, which was developed by behavioural economist, James Montier. This consists of the following six questions which have binary answers with 1 point awarded for “yes”, zero for “no”.
Growing divergence between net income and cash flow?
Increasing receivable days?
Increasing inventory days?
Increasing other current assets?
Declines in depreciation relative to gross fixed assets?
Total asset growth above 10 per cent?
The C-Score is designed to flag manipulation of accounts. A transparent balance sheet has a low C-Score. The rationale for each question is obvious. Higher profits matched to lower cash flow indicates a problem somewhere. Increases in receivables and inventories indicate unduly accelerated revenue recognition, and slowing sales growth, which can mean liquidity problems in an apparently profitable entity. Rising current assets is similar to higher receivables. Lower depreciation can be caused by attempts to report higher net profits. Mergers and acquisitions can obfuscate profitability, or the lack of it.
Given that accounts manipulation accounts is common in India, and also that profitability has been low for a while, using the C-Score can be useful. These two scores are not hard to calculate and both should be applied as basic hygiene, before one buys into any company, especially now.