LONDON -- You don't need me to tell you how the banking crash and recession have pushed many companies to the brink of bankruptcy. Shares such as Barclays, Nokia, and Home Retail Group have collapsed 80% or more since the credit crunch erupted. With the future in Europe and the banking sector still far from certain, many more companies could be at risk of going the same way.
Like you, no doubt, I'm always keen to ensure my potential investments aren't just about to go bust! Indeed, I'm convinced avoiding losers is just as important as picking winners in today's choppy market.
With all that in mind, I use something called a Z-Score to help me sidestep portfolio disasters. The Z-Score was developed in the 1960s and evaluates various financial ratios to provide an overall verdict on a company's strength. Effectively, the higher the number, the less likely the company is to go bust, although of course this is best taken in context of the Z-Score of its industry as a whole. Generally speaking, a score above 3 suggests the company is in very good health, while a score below 1.8 indicates the possibility of the firm going under. The Z-Score is not perfect, of course, and I would encourage you, if you are interested, to read more details.
Today I'm assessing GlaxoSmithKline (ISE: GSK.L) . Here are my Z-Score calculations:
Working Capital/Total Assets
Retained Earnings/Total Assets
Market Value of Equity/Total Liabilities
This comparison looked at the full-year results for Glaxo ending Dec. 31, 2011, and compares the figures with the same reports for a number of rival firms, including AstraZeneca and Shire.
The results show that Glaxo's Z-Score came in almost 20% lower than the sector average, due in main part to a comparatively high level of total liabilities. This saw the market-value-to-liabilities ratio also fall below the sector, despite the company's market value of equity itself actually coming in line with that of its competitors.
Between 2010 and 2011 Glaxo's Z-Score increased by 18% from 2.38, while the sector average increased by just 13%. This gain mainly derived from the EBIT-to-total-assets ratio, which more than doubled through the period following a sharp rise in operating profit, as well as the liquidating of some assets for the company.
Glaxo's weakest comparative area is that of retained earnings to total assets, where despite fairly similar levels of assets to its equally-sized peers, a very low level of retained earnings for the firm has this ratio at less than half of the sector's.
Significantly, both working capital and retained earnings for Glaxo dropped by relatively large amounts between 2010 and 2011, and although the retained-earnings-to-total-assets ratio fell 27% in the period (compared to a 21% increase for the sector), the move in retained earnings to total assets actually came in line with a similar decline for the industry.
So we have a mixed picture, then. At 2.82, Glaxo's Z-Score is still well into "strong" territory, although not to the levels of the industry as a whole, which could be worrying. Certainly, falling working capital and comparatively low retained earnings could be a problem in an industry where investment and development of new drugs are vital.
However, while there may be better pharmaceutical companies to buy if you are looking for an investment, GlaxoSmithKline isn't going to go bust anytime soon.
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The article Could GlaxoSmithKline Go Bust? originally appeared on Fool.com.
Karl Loomes does not own any of the shares mentioned in this article.The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
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