Tools › Investing › Stock Valuation › Financial Quality Scores › Method
Financial Quality Scores: Method
Open the Financial Quality Scores tool
Financial Quality Scores: Three Published Accounting Screens
What it does
The page takes a handful of lines from two years of a company's financial statements and works through three screens that researchers built from such lines. A screen is a fixed recipe: it turns the statements into a number in the same way for every company. The page shows each ratio and each test so that you can see what the recipe looks at. It reports the numbers; it does not say whether the company is sound or whether its shares are worth owning.
The screens: the Piotroski F-score (nine pass-or-fail tests), the DuPont decomposition of return on equity, and, in Advanced mode, the Altman Z-score and the accruals ratio.
The method
Subscript 1 is this year, 0 is last year. NI = net income, CFO = cash flow from operations, TA = total assets, CA and CL = current assets and current liabilities, LTD = long-term debt, GP = gross profit, Rev = revenue, Eq = shareholders' equity.
Piotroski F-score (Piotroski 2000). One point for each test passed, total 0 to 9.
| Test | Passes when |
|---|---|
| 1. Return on assets | ROA1 = NI1 / TA1 is positive |
| 2. Operating cash flow | CFO1 / TA1 is positive |
| 3. Change in ROA | ROA1 > ROA0 |
| 4. Accruals | CFO1 / TA1 > ROA1 (cash flow exceeds net income) |
| 5. Leverage | LTD1 / TA1 < LTD0 / TA0 |
| 6. Liquidity | current ratio CA1 / CL1 > CA0 / CL0 |
| 7. New shares | shares1 ≤ shares0 (no shares issued) |
| 8. Gross margin | GP1 / Rev1 > GP0 / Rev0 |
| 9. Asset turnover | Rev1 / TA1 > Rev0 / TA0 |
Tests 1 to 4 concern profitability, 5 to 7 debt, liquidity and funding, 8 and 9 operating efficiency. A tie counts as a fail, as in the paper, where a signal is 1 only if the quantity is "positive", "fell" or "improved".
DuPont decomposition. Return on equity ROE = NI / Eq is written as a product of three ratios in which revenue and total assets cancel:
ROE = (NI / Rev) × (Rev / TA) × (TA / Eq) = profit margin × asset turnover × equity multiplier
The equity multiplier measures leverage: assets per 1 of equity. The five-step form (Advanced) splits the margin further, with EBT = pretax income and EBIT = operating income:
ROE = (NI / EBT) × (EBT / EBIT) × (EBIT / Rev) × (Rev / TA) × (TA / Eq) = tax burden × interest burden × operating margin × asset turnover × equity multiplier
The page computes every factor for both years and its relative change, factor1 / factor0 − 1. Because ROE is a product, (1 + change in margin)(1 + change in turnover)(1 + change in multiplier) − 1 equals the relative change in ROE exactly.
Altman Z-score (Altman 1968; Advanced). With X1 = (CA − CL) / TA, X2 = retained earnings / TA, X3 = EBIT / TA, X4 = equity / total liabilities, X5 = Rev / TA, and total liabilities = TA − Eq:
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5, with X4 on the market value of the equity (share price × shares); boundaries 1.81 and 2.99
Z′ = 0.717 X1 + 0.847 X2 + 3.107 X3 + 0.420 X4 + 0.998 X5, with X4 on the book value of the equity; boundaries 1.23 and 2.90
Z″ = 6.56 X1 + 3.26 X2 + 6.72 X3 + 1.05 X4, book equity, no turnover term; boundaries 1.10 and 2.60
In the 1968 sample no company that went bankrupt scored above the upper boundary and no company that survived scored below the lower one; between them, Altman's "zone of ignorance", both kinds were found. The page prints the boundaries beside the score and leaves the comparison to you.
Accruals ratio (Sloan 1996; Advanced). Accruals are the part of earnings not received in cash. Two ways to measure them, each divided by average total assets (TA1 + TA0) / 2:
cash-flow form: NI1 − CFO1
balance-sheet form: (change in CA − change in cash) − (change in CL − change in short-term debt) − depreciation
Sloan's own form also takes the change in income taxes payable out of the current liabilities; add that line to the short-term debt field if the balance sheet shows it.
What it assumes
Closing balances. Every ratio of a year uses that year's closing balance sheet, because two balance sheets are entered. Piotroski divides net income, cash flow and revenue by the assets at the start of the year, and long-term debt by the average assets of the year; that needs a third balance sheet. The pass or fail of a test can differ from the paper's own definition when total assets changed a great deal.
Share count as the sign of a share issue. The paper asks whether the company sold common shares during the year. The page compares the two share counts, so a company that issued shares and bought back more passes, and a share split not adjusted for fails.
The statements as reported. Nothing is adjusted for one-off items, acquisitions, changes of accounting rules or different year lengths.
When it misleads
Each screen was built on one sample. Piotroski studied only U.S. companies in the highest fifth by book-to-market ratio (14,043 company-years, 1976 to 1996), many of them small and in difficulty; he reported that high-scoring companies in that group earned higher returns in the following year than low-scoring ones. The paper does not test the score on other kinds of company. Altman fitted the Z-score to 66 U.S. manufacturers, 33 of which filed for bankruptcy between 1946 and 1965, with assets of 1 to 25 million dollars in the comparison group. Sloan studied U.S. listed companies from 1962 to 1991. A result found in one group and period need not hold in another, and none of them is a statement about a single company.
The F-score counts, it does not measure. A gross margin that rose by a hundredth of a point scores the same as one that rose by ten points, and a tie fails. A company can lose a point because an already high ratio slipped slightly.
The Z-score depends on the kind of company. Asset turnover (X5) differs widely between industries, and X4 in the original form moves with the share price, so the score rises in a rising market. The sample held no financial companies. For companies unlike the sample, for example large service or technology companies, or companies whose equity is small or negative after years of share repurchases, the ratios fall outside anything the sample contained and the boundaries have no tested meaning.
ROE flatters leverage. A small equity gives a high ROE whatever the business earns on its assets. Read ROE with its three parts, and note that the decomposition is not defined when equity is zero or negative.
Accruals differ by industry and by growth. A growing company adds receivables and inventories and so has positive accruals; that is ordinary. The two forms disagree after acquisitions and disposals.
Worked example
The default case uses Apple Inc.'s Form 10-K for the fiscal year ended 30 September 2023, in millions of dollars, with fiscal 2022 as last year. Fiscal 2023 / 2022: revenue 383,285 / 394,328; gross profit 169,148 / 170,782; net income 96,995 / 99,803; operating cash flow 110,543 / 122,151; total assets 352,583 / 352,755; current assets 143,566 / 135,405; current liabilities 145,308 / 153,982; long-term debt 95,281 / 98,959; equity 62,146 / 50,672; shares 15,550 / 15,943 million.
F-score. ROA = 96,995 / 352,583 = 27.51 % (positive: pass) against 99,803 / 352,755 = 28.29 % last year (did not rise: fail). Cash return = 110,543 / 352,583 = 31.35 % (positive: pass; above ROA: pass). Leverage 95,281 / 352,583 = 27.02 % against 28.05 % (fell: pass). Current ratio 143,566 / 145,308 = 0.988 against 0.879 (rose: pass). Shares 15,550 against 15,943 (no increase: pass). Gross margin 169,148 / 383,285 = 44.13 % against 43.31 % (rose: pass). Turnover 383,285 / 352,583 = 1.087 against 1.118 (did not rise: fail). F = 1 + 1 + 0 + 1 + 1 + 1 + 1 + 1 + 0 = 7.
DuPont. Margin 96,995 / 383,285 = 25.306 %; turnover 1.087; multiplier 352,583 / 62,146 = 5.673; ROE = 25.306 × 1.087 × 5.673 = 156.08 %, the same as 96,995 / 62,146. Last year: 25.310 % × 1.118 × 6.962 = 196.96 %. The margin was unchanged (−0.01 %), turnover fell 2.75 % and the multiplier fell 18.50 %: (1 − 0.0001)(1 − 0.0275)(1 − 0.1850) − 1 = −20.76 %, the relative change in ROE. Nearly all of the change came from the equity multiplier, as the equity rose from 50,672 to 62,146 on almost unchanged assets.
Advanced. With operating income 114,301, pretax income 113,736, retained earnings −214 and an illustrative share price of 175 (a round figure for early November 2023, not a quotation): X1 = −1,742 / 352,583 = −0.0049; X2 = −0.0006; X3 = 0.3242; X4 = 175 × 15,550 / 290,437 = 9.3695; X5 = 1.0871; Z = 7.772, of which 5.62 comes from the market-value term. Accruals, cash-flow form: (96,995 − 110,543) / 352,669 = −3.84 %; balance-sheet form, with cash and current securities 61,555 / 48,304, short-term debt 15,807 / 21,110 and depreciation 11,519: [(8,161 − 13,251) − (−8,674 + 5,303) − 11,519] / 352,669 = −3.75 %.
For the Beneish M-score and a full ratio set, see the Financial Ratios tool.
A calculator for education and analysis, not investment advice.