Joseph Piotroski published academic work showing nine accounting variables were useful in differentiating between those firms whose share returns are negatively affected by potential financial distress and those that are likely to outperform based on a good score regarding financial distress indicators.
The indicators fall under three headings: (1) Profitability; (2) Leverage, liquidity, and source of funds, and; (3) Operating efficiency
Profitability factors
If the firm is profitable and produces positive cash flow it has a capacity to generate funds internally. A positive earnings trend suggests an improvement in the firm’s ability to generate positive future cash flows.
- Positive net income before extraordinary items for the year to end July 2020? J Smart (LSE:SMJ) is profitable (£3.6m) and has been for many years. A score of one is given.
- Positive cash flow from operations before investment in working capital? Yes (£4.9m), so we can add another one to the score.
- Improvement in return on assets employed in the business from the previous year? Net profit/beginning of year total assets: 2019: £6.2m/£114m = 5.4%, 2020: £3.7m/£118m = 3.1%. A reduction, therefore no point.
- Is cash flow greater than profit (so profits are not driven primarily by positive accruals, which may be ‘managed’)? Yes, so a third Piotroski point.
Leverage, liquidity, and source of funds
- Change in leverage over one year. Has the firm’s long-term debt reduced relative to its total assets? At 31st July 2020 the company had net cash of £13m. Fourth Piotroski point.
- Has the firm’s current ratio (current assets divided by current liabilities) improved over the past year? 2019: £37.8m/£16.4m = 2.3, 2020: £32.7m/£13.2m = 2.5. The current ratio has improved for J Smart. Fifth Piotroski point.
- Has the firm avoided raising fresh equity capital (e.g. rights issue or placing) in the last year? J Smart has not had to raise money this way. This takes us to six points.
Operating efficiency
- Has the gross………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1