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By David Sterman

When it comes to analyzing balance sheets, there are retailers, and there is everyone else. Retail-based businesses need to worry about inventory levels, sales markdowns, cash balances and many other balance sheet items throughout the year, especially as many are profitable only during the holidays.

That's why Edward Altman, professor of New York University's Stern School of Business, devised a broad measure of a retailer's financial health. Ever since he developed his "Z-Score" methodology in 1968, investors have been using his gauge to see how their own retail investments are stacking up.

Red, Yellow And Green
Altman's Z-Score gives one simple number that tells you how a retailer is faring. Any reading above 3.0 implies good health in terms of balance sheet strength and profit results. Indeed, the vast majority of retailers get the thumbs-up using the Z-Score.

But a reading of 3.0 and below should be cause for concern. The lower the number, the greater the risk that this retailer won't be around in a few years. Indeed, retailers such as Circuit City, Bombay, Ames and others showed declining Z-Scores before going belly-up.

Let's start with a look at retailers with mediocre Z-Scores, in the 2.5 to 3.0 range.

These companies are in the process of either boosting or weakening their Z-Scores, so it's wise to see how this number trends over time. For example, electronics retailer Conn's (NASDAQ:CONN) was in weak shape a few years ago, but has recently posted improving sales and profit trends. If those trends continue, then its Z-Score will eventually move into safer territory.

Before looking at companies with truly concerning Z-Scores, let's look at how this number is determined. Altman takes a wide variety of variables from the balance sheet, income statement and cash flow statement, creates a set of ratios for various metrics, and then assigns weights to those ratios.

Here's the formula:

Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

A = Working Capital/Total Assets

B = Retained Earnings/Total Assets

C = Earnings Before Interest & Tax/Total Assets

D = Market Value of Equity/Total Liabilities

E = Sales/Total Assets

I ran these variables through a screening tool (provided by Thomson Reuters), eliminating any retailer with a Z-Score of 4.0 or higher. You can see how all retailers fared.

Now, let's take a look at the retailers that may soon hit a wave of financial distress.

Here again, it's wise to dig into the numbers and confirm the trend, as some retailers' financial pictures are changing quickly. For example, supermarket chain Supervalu (NYSE:SVU) has raised much-needed cash through asset sales and is out of intensive care -- for now. On the other hand, women's apparel retailer Coldwater Creek (NASDAQ:CWTR) appears headed for further losses in the years ahead, which is bound to weaken its financial foundation even more.

A retailer showing deep warning signs: Sears Holdings (NASDAQ:SHLD), which I profiled on our sister site ProfitableTrading.com.

Though shares are off more than 10% since I panned the stock a month ago, there is considerably more downside to go as cash flies out the door in coming quarters.

It's also important for investors to track the turnaround efforts at J.C. Penney (NYSE:JCP). The struggling retailer is expected to keep losing money at a furious pace, which may eventually create deepening liquidity concerns. Then again, if the company can stabilize and actually turn a profit (compared with a current projected loss of $1.25 a share), then this might shape up as a nice turnaround play.

Risks to Consider: As an upside risk, a strengthening U.S. economy will likely give a solid boost to retail sales, aiding many of these struggling retailers.

The ongoing shift toward e-commerce is likely to create further pressure on brick-and-mortar retailers. For example, Barnes & Noble (NYSE:BKS) recently noted very weak sales trends, which could trigger a wave of further store closings, pushing this retailer even closer to the brink. A number of retailers will report monthly same-store sales trends in the coming days, and if you spot any weak sales trends, be sure to calculate the firm's Z-Score to see if it might be headed for deeper distress.

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