At this writing, some pundits are telling us
that the worst is over and this is the time to start picking up bargains.
Maybe yes, maybe no. However, if you’re in that camp, you need to know
that the corporate credit market is tight, to put it mildly. Should that
condition persist, shareholders of corporations that rely on debt to
finance growth could be in for some unpleasant surprises.
With that in mind, I’ve devised a score sheet
to help you evaluate the credit-related risk of owning a particular stock.
The score sheet evaluates five relevant factors. Each factor can add zero
to two risk points to your score. The higher the score, the higher the
You can find the needed information on many
financial sites. I’ll use Smart Money (www.smartmoney.com)
to demonstrate the process. Start by getting a
price quote for your stock and then selecting
Debt Adds Risk
Normally, using debt to finance growth is not a problem. After all, it
makes sense to borrow, at, say, 6% interest, if you put the money to work
at 10%. However, eventually, all debt must be renewed or refinanced, and
therein lies the problem. Most firms will, at best, end up paying higher
carrying charges when that happens. At worst, they may not be able to be
able to renew or refinance all of their debt.
The total debt to equity ratio compares the
total of short- and long-term debt to shareholders equity (book value).
Zero ratios signal no debt, and the higher the ratio, the higher the debt.
Usually ratios below 0.4 or so qualify as low-debt. However, now, any debt
adds risk. Add one risk point for ratios between 0.1 and 0.5 and
two risk points for ratios above 0.5.
Cash In Bank
Even firms passing the debt/equity test may find themselves short of cash
when it comes to paying current bills. That’s where the quick ratio comes
into play. It gauges ready cash by comparing liquid current assets to
current bills. Liquid current assets include cash in the bank and accounts
receivables (cash owed to the firm by its customers). Current bills
include rent, salaries, utility bills and the like. A quick ratio of 1
means that liquid assets equal current bills. However, not all accounts
receivables will convert to cash in a timely manner, especially in a
slowing economy. Thus, an extra cushion is required. Add one risk point
for quick ratios below 1.5 and two risk points for ratios below
A firm must be profitable, otherwise, its cash position would deteriorate.
But, profitability involves more than reporting positive earnings per
share. For example, consider two firms that each reported $1 million net
income. However, one company’s shareholders had to sink $100 million into
the business to generate those earnings while the second firm’s
shareholders only had to invest $20 million.
That’s why many professionals employ
profitability ratios such as return on equity, which compares net income
to shareholders equity, to gauge return on shareholders’ investment. Many
money managers require a minimum 15% ROE before they will invest in a
company. Lower ROEs increase the probability that a firm would have to
borrow to finance growth.
Add one risk point for ROEs below 15,
and two risk points for negative ROEs, which signal that the firm
is losing money.
Check Cash Flow
Thanks to flexible accounting rules, some apparently profitable firms are
actually losing money when you count the cash. Thus, it’s important to
check cash flow, which is the amount of money that actually moved into, or
out of, a firm’s bank accounts during the reporting period. For our risk
score, we only need only need to know whether cash flowed in or out. You
can determine that by checking the “cash flow from continuing operations”
figure. Given the importance of cash in this market, add two risk
points if that number is negative, meaning that cash flowed out.
Our historical cash and profitability checks are for naught if earnings
shrink or turn to losses. We can reduce the likelihood of that happening
by checking analysts’ consensus earnings forecasts, which are the average
forecasts from all analysts covering a stock. Yes, I know that analysts
can be off, but forecasting earnings is their day job, and their numbers
are likely to be better than anything we could come up with on our own.
Find the forecasts by selecting
Earnings from the top menu and then check the “Year Ending” percentage
growth forecasts listed in the Growth Estimates section. Since we’ve
already evaluated current conditions, we only need a modest earnings
growth cushion to assure that a firm’s cash position doesn’t deteriorate.
Of course, as mentioned above, negative earnings growth spells trouble.
Add one risk point if the growth
forecasts for the current or next fiscal year are less than
5% and add two risk points for negative
Total your credit risk score
for each stock you want to evaluate. Zero scores are your best bets and
scores of three or more signal high risk.
Keep in mind that this score sheet only identifies stocks likely to
be tripped up by problems triggered by the tight credit markets. Low
credit risk doesn't mean that a stock won’t be tripped up by other
problems such as slowing growth. Do your due diligence. The more you know
about your stocks, the better your results.