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Use
Cash Flow to Spot Bankruptcy Candidates
Cash flow analysis
Consolidated
Freightways made headlines last week when it filed bankruptcy and ceased
operations. According to news reports, Consolidated’s shareholders
were likely to lose their entire investment.
We’ve heard
a lot recently about investors being duped by accounting fraud. But
Consolidated simply ran out of cash to pay its bills. Any investor with
access to the Internet could have used its cash flow statements to
determine that Consolidated was risky
business months ago.
Analyze
Cash Flow
Consolidated
was a cash burner in recent years, meaning that it used more cash than
it made. Because of the way accounting is done, it’s possible for
firms to appear profitable, but lose money on a cash basis. That is why
many investors pay more attention to cash flow than to reported
earnings.
Any firm can
have a bad year, but habitual cash burners must replenish their cash by
borrowing or selling more shares to stay afloat. Both approaches reduce
per-share earnings, and consequently are bad news for existing
shareholders, even in the best of times. Therefore, some investors shun
cash burners even if solvency is not an issue.
Cash Burn Rate
vs. Working Capital
You can find out if a cash burner is a bankruptcy candidate by comparing
its “burn rate” to its working capital. Burn rate is the amount of
cash used each month, and working capital is the money available to
finance day-to-day operations (current assets minus current
liabilities).
You can
estimate the monthly burn rate by dividing a firm’s recent 12
month’s cash flow by 12. For instance, the burn rate was $10 million
per month if the firm’s cash flow amounted to a negative $120 million
during the most recent 12 months ($120 million divided by 12).
The next step
is to estimate how long the working capital will last if the firm
continues burning cash at the same rate. For example, it has a
six-month’s supply of cash if it’s burning $10 million monthly and
has $60 million working capital ($60 million divided by $10 million).
Morningstar's
User-Friendly Cash Flow Report
You can find the needed information to do the analysis on many websites,
but Morningstar’s Financials report presents the data in a
particularly user-friendly format. Get there from Morningstar’s
mainpage (www.morningstar.com)
by getting a quote and then selecting the Financials
report (5 Years).
Scroll down
to the Cash Flow data. Morningstar displays three cash flow data items
for the last four reported quarters (trailing 12-months) and for each of
the last three fiscal years. Use the trailing 12-months figures to
estimate future cash flows unless they are clearly inconsistent with the
older results.
The first
item, operating cash flow, is the money that flowed in or out of the
firm’s bank accounts from its main operations.
Next is
capital spending, the cash used to acquire plants and equipment.
Finally, free cash flow is operating cash flow less capital spending.
Solvency
issues aside, many investors require candidates to show strong positive
operating cash flow. As a rule of thumb, the operating cash flow should
exceed the net income for the same period. Some investors are even more
stringent and also require strong positive free cash flow. At a minimum,
you’d be well served by disqualifying candidates reporting persistent
negative free cash flow.
Consolidated
Was Burning Cash
Morningstar
reported Consolidated’s operating cash flow as a negative $34 million
for the trailing twelve months ending in March 2002. Adding capital
spending drove the free cash flow total to a negative $77 million.
However, I usually use the operating cash flow for this analysis because
cash-poor firms will likely curtail capital spending. On that basis,
Consolidated was burning cash at the rate of $2.8 million monthly ($34
mil divided by 12).
You can
determine Consolidated’s working capital by adding its cash to its
“other current assets,” and then subtracting its current
liabilities. Doing that calculation using Consolidated’s March quarter
numbers yielded a negative $21 million ($13 million cash plus $404 mil
other current assets minus $438 mil current liabilities).
Yikes,
Consolidated was already out of cash! In other words, Consolidated was
technically insolvent. You would have found the same result if you had
done the analysis earlier in the year when Consolidated’s 2001
year-end figures became available.
Consolidated
last reported positive working cash flow ($19 million) as of September
30, 2001. You would have determined that Consolidated had about seven
months cash supply if you had done the analysis last year using its
September results and assuming that it was burning $2.8 million
per-month back then.
How Much
is Enough?
How much
working capital is enough? There is no hard and fast rule, but less than
a year’s supply clearly signals danger. Probably a two-year or longer
supply is not a cause for alarm, at least in terms of bankruptcy. Many
firms have a good shot at solving their problems with that much time.
Obviously,
not every firm that doesn’t meet these requirements will file
bankruptcy. Some will manage to raise the funds required to keep
operating, and others will be acquired.
Performing
this simple analysis will flag many firms with a high bankruptcy risk.
But it doesn’t assure that a heavily indebted firm is generating
enough cash to service its debts. Consequently, it’s best to avoid
unprofitable firms with total debt to equity ratios of 0.4 or higher
unless you’re willing to perform a detailed financial strength
analysis.
published 9/8/02 |
