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Is Capita (LON:CPI)'s weak balance sheet cause for concern?

22nd Mar '19 by Jack Brumby

Business distress can hurt your portfolio no matter how well diversified you are.

That's why paying attention to simple checklists that flag up risky stocks is so important. One such checklist - the Altman Z-Score - was found to be:

  • 72% accurate in predicting bankruptcy two years prior to the event in its initial test
  • 80-90% accurate in predicting bankruptcy one year before the event in the 31 years up until 1999

That's quite the vote of confidence. The Z-Score was developed by New York University finance professor and leading academic, Edward I. Altman. It measures how closely a firm resembles other firms that have filed for bankruptcy by considering the following areas:

  • Current assets as a proportion of total assets,
  • Cumulative profitability and use of leverage,
  • Productivity of assets, and
  • Firm value compared to liabilities

A Z-Score of more than 2.99 is considered safe. Those with a Z-Score of less than 1.8, on the other hand, have been shown to have a significant risk of financial distress within two years. We can see the checklist in action by applying it to a listed company. 

Take mid-cap business process management outsourcer Capita (LON:CPI), for example. 

GET MORE DATA-DRIVEN INSIGHTS INTO LON:CPI »

What does the Altman Z-Score flag up about Capita (LON:CPI)?

Unfortunately, Capita fails Altman’s test, with a worryingly low Z-Score of -0.81...

Capita's low Z-Score doesn't mean that it is definitely heading for financial distress, but it does mean this fate is more of a risk for Capita than it is for most. When you consider the recent disasters in the UK outsourcing sector, such as Serco, however, it pays to be cautious.

Specifically, our algorithms flag the following as risks:

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In 2009, Morgan Stanley strategy analyst, Graham Secker, used the Z-score to rank a basket of European companies. He found that the companies with weaker balance sheets underperformed the market more than two-thirds of the time. This quick look at Capita shows that it also has weak spots that require further investigation.

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The problem areas for Capita identified here can be explored in more depth on Stockopedia's research platform. All the best investors have stringent due diligence processes that reduce the chances of them suffering big losses, so why not take a leaf out of their book?

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