Financial strength test for high-debt companies

Joseph Piotroski, an accounting professor at the University of Chicago, devised a financial fitness scoring system in order to determine whether a company is financially weak. Although his scoring system is intended for value (distressed) stocks, it can be applied to any high-debt company. If the total liabilities to equity (total assets minus the total liabilities) ratio is higher than 0.5, the company is considered a high-debtor (see the financial strength evaluation post). Harry Domash, an expert in analyzing stocks (see his winning investing website), very slightly modified the Piotroski test (added two additional tests) and this is his system that is presented here below. The way it works is that you award one point if the company passes each test and tally the points at the end. It is of course a bit simplistic since there is no weighting for the various tests (not all tests are equal regarding what conclusions can be drawn from them) but it is certainly better than nothing.

Profitability

1. Net Income. Award one point if the net income is positive.
2. Operating Cash Flow. Award one point if the operating cash flow is positive.
3. Return on Assets (net income divided by total assets). Award one point for a year-over-year increase.
4. Quality of Earnings. Award one point if the operating cash flow is greater than the net income.

Debt and Capital

5. Total liabilities to Total Assets ratio. Award one point for a year-over-year decrease. Note that Piotroski uses long term debt instead of total liabilities.
6. Working Capital (current assets minus current liabilities). Award one point for a year-over-year increase.
7. Shares Outstanding. Award one point if the number of shares outstanding increased by less than 2 percent. Note that Piotroski requires the number of shares outstanding to not increase at all.

Operating Efficiency

8. Gross Margin (gross income divided by sales). Award one point for a year-over-year increase.
9. Asset Turnover (revenues divided by total assets). Award one point for a year-over-year increase.

Added Tests

10. Total liabilities to EBITDA (earnings before interest, taxes, depreciation and amortization) ratio. This ratio is known as the investment quality ratio in the lending business. Award one point if the ratio is 5 or lower. Deduct one point if the ratio is 8 or above.
11. Total Liabilities to Operating Cash Flow ratio. Award one point if the ratio is less than 4.

There you have it! All you need to do is tally up the scores. A company scoring 5 points or more receives a passing grade (same as Piotroski). Of course, the higher the score, the better. A company with a failing score is not guaranteed to go bankrupt but staying away from it would be a good idea. Please check the financial strength test for high-debt companies (example) post for how it works in real life.