Harry Domash's Winning Investing


Credit Risk Scorecard

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 risk. 

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 Key Stats.

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 0.5. 

Profitability Counts
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.

Future Earnings
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 forecasts.

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.

More Work Required
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.

published 4/13/08

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