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Check
Fiscal Fitness First
With the stock market looking like it’s settling down, some investors
will be tempted to jump back in. If you’re in that camp, you’d be wise
to pay close attention to a firm’s financial strength, just in case the
credit markets turn another somersault.
Given current conditions, the last thing you want to hear is that one of
your stocks is running short of cash. A firm doesn’t have to file for
bankruptcy to ruin your day. Just rumors that it might have trouble
refinancing current debt would be enough to drive its share price into
the ground.
Here’s a short list of only four items that you can use to analyze the
fiscal fitness of stocks that you already own or are thinking of buying.
You won’t need your calculator and you won’t have to scrutinize
financial statements. Forbes (www.forbes.com)
lists everything you need to know.
I’ll demonstrate the process using three examples, recently failed
department store Gottschalk’s, grocery store chain Whole Foods Markets
(WFMI), and restaurant operator Chipolte Mexican Grill
(CMG).
For Chipolte, Whole Foods, and all other stocks, find the needed
information on Forbes Ratios & Returns report. You’ll have to take my
word about Gottschalk’s numbers. Gottschalk’s filed for bankruptcy in
January 2009 and its stock is no longer trading. Consequently, you can’t
access Gottschalk’s data on Forbes. Otherwise, enter the ticker symbol
on Forbes’ homepage and then select “Ratios
& Returns.” We’ll start with debt.
Financial Leverage
Financial leverage, a term you’ve probably heard a lot about lately, is
a comprehensive debt measure. In essence, it compares a firm’s total
liabilities to shareholders equity (assets minus liabilities).
Leverage is a better debt measure than the more common debt to equity
ratio. Some firms list debt items in balance sheet categories that don’t
get counted in the D/E ratio, but financial leverage counts everything.
A leverage ratio of 1 signals no debt and the higher the ratio, the
higher the debt.
The median (as many stocks above as below) leverage ratio for all stocks
is around 2.5. However, banks and other financial institutions carry
higher ratios, typically between 5 and 15. For them, borrowed cash is
their inventory. Since the goal is to avoid high-debt firms, rule out
stocks with leverage higher than 2.5 and give preference to firms with
ratios below 2.0.
Gottschalk’s, with 3.9 leverage ratio, as of its November 30, 2008
quarterly report, wouldn’t have made the cut. Forbes listed Chipolte’s
leverage at 1.3 and Whole Foods at 2.4. So Chipolte is definitely low
debt, while Whole Foods is marginal.
Checking debt only tells half the story. We also need to know if a firm
has enough cash in the bank to pay its current bills. For that, you need
to check the “quick ratio.”
Cash on Hand
The quick ratio compares available cash to current liabilities.
Available cash includes cash in the bank plus receivables (money owed
the company by its customers). Current liabilities include all
short-term expenses such as payroll, advertising, utilities, rent, etc.
We want to see ratios higher than one, which means that available cash
exceeds current liabilities. Conversely, we want to avoid ratios below
one which signals that the firm doesn’t have enough cash on hand to pay
its current bills. Require quick ratios of at least 1 and give
preference to firms with ratios of 1.5 or higher.
As of November 2008, Gottschalk’s quick ratio was 0.1, meaning that its
short-term liabilities overwhelmed available cash by a 10-to-1 margin.
However, Forbes showed Chipolte’s quick ratio at 2.7, signaling that
available cash was almost triple current liabilities. Whole Foods 0.6
quick ratio warns that the chain will soon have to come up with
additional cash.
Finally, we’ll check two items that will tell us something about a
firm’s future prospects, in terms of financial strength.
Positive Earnings
Obviously, profitable firms are less likely to run into future financial
problems than money losers. The profitability measure “return on assets”
compares net income to total assets. ROA can only be positive if the
last 12-months net income was a positive number. Thus, any positive ROA
passes, but giver preference to firms with ROAs above 5 and higher is
better.
Gottschalk’s racked up losses in its November quarter as well as in the
preceding two quarters, resulting in a negative ROA. The ROAs for
Chipolte and Whole Foods were 9.5 and 3.0, respectively.
Check Cash Flow
Sometimes companies report positive earnings, but when you count the
cash, you find that they actually lost money. Operating cash flow is the
cash that moved into, or out of, a firm’s bank accounts resulting from
its main business. From a balance sheet perspective, it’s always a
problem when cash is flowing out (burning cash) rather than in. Thus,
positive cash flow is a prerequisite for financial strength. Use Forbes’
“cash flow per share” and require a positive number. For our purposes,
as long as the number is positive, the amount isn’t significant.
Gottschalk’s November quarter’s cash flow was negative, so it would have
flunked the cash flow test. The cash flow per-share figures for Chipolte
and Whole Foods were $3.97 and $2.55 respectively. So, Chipolte and
Whole Foods both passed.
These fiscal fitness tests measure balance sheet risk, but not every
firm that flunks will run into financial problems. Conversely, passing
doesn’t mean that you’ll make money owning the stock. Determining that
requires further analysis.
published 4/12/09 |
