Check
Fiscal Fitness First
Just because the stock market is looking
stronger these days doesn’t mean that you should throw caution to the
wind. Up or down market, you’ll always do best owning stocks with rock
solid balance sheets. Why?
The action of raising new cash by borrowing
or selling new shares always reduces the value of a firm’s stock.
Servicing additional debt cuts net income, and selling more shares
shrinks earnings per share by increasing the number
of shares outstanding.
Here are four quick checks that you can use
to analyze the fiscal fitness of stock that you’re thinking of buying or
that you already own. The good news is that you won’t have to don green
eyeshades to do these checks. In fact, you won’t even need to dust off
your calculator.
You can find all of the information
that you need is on MSN
Money (money.msn.com).
Once you get the hang of
it, you’ll be able to check almost any stock in less than a minute (no
kidding).
I’ll demonstrate the process using four
stocks; Apple (AAPL), Groupon (GRPN), Zillow (Z). and Netflix (NFLX).
Start by entering your stock's ticker symbol and then
clicking on Key Ratios under Fundamentals on the left-hand menu.
We’ll start with a useful all-purpose debt
measure.
Leverage
Ratio
Leverage is a better debt measure than the more common debt to equity
ratio. Sometimes creative accountants list debt items in balance sheet
categories that don’t get counted in the D/E ratio, but the leverage
ratio counts everything. A leverage ratio of 1 signals no debt and the
higher the ratio, the higher the debt. Click on
Financial Condition to see the leverage ratio for your stock.
As a rule of thumb, ratios below 2.5
describe low-debt firms and those with ratios above 5.0 are high-debt.
For this check, award one point for ratios below 2.5, zero for ratios
between 2.5 and 5.0, and subtract one point for ratios above 5.0. Here’s
how our four stocks fared.
Apple: Leverage 1.7, one point. Groupon: Lev
2.8, zero points, Zillow Lev 1.1, one point, and Netflix: Lev
4.0, zero points.
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.
Cash on
Hand
The quick ratio compares available cash to current liabilities. The
ratio is one when available cash equals current liabilities.
You can see the quick ratio in the Financial
Condition section, the same as for leverage. Ratios
above one signals excess cash and ratios below one signal a cash
shortage.
Score one point for ratios above 1.0, zero
when the quick ratio equals 1.0, and subtract one for ratios below 1.0
Apple: QR 1.3, one point. Groupon: QR
0.9,
minus one point, Zillow QR
1.1, one point, and Netflix: QR 0.7, minus one
point.
Finally, we’ll check two items that will
tell us something about a firm’s future prospects, in terms of financial
strength.
Positive
Earnings
You don't need an MBA to realize know that profitable firms are less likely to run short of cash than
money losers. The profitability measure “return on assets” compares net
income to total assets. Positive ROA values correspond to positive
earnings and vice versa. However, for ROA, higher is better and low ROA
values signal marginally profitable firms. You can
find your stock's ROA in the "Inv Returns" section.
Score one point for positive ROA values
above 10.0, zero for positive values below 10.0 and subtract one point
for negative ROAs.
Apple: ROA 18.8, one point. Groupon: ROA
-6.1, minus one point, Zillow ROA -3.2,
minus one point, and Netflix: ROA 3.1, zero.
Check
Cash Flow
Oftentimes 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. Cash flow is positive when cash is flowing in and
negative when it’s flowing out (burning cash).
We’ll use the
"price/cash flow ratio" to determine which way cash is moving. The ratio
will be positive when cash is flowing in and negative when the firm is
burning cash. Find the price/cash flow ratio in the Price Ratios
section, For this check, the value of the ratio isn't significant.
So, add one point for positive price/cash flow
ratios and subtract one point for negative
ratios.
Apple: P/CF
10, one point. Groupon:
P/CF 22, one point, Zillow
P/CF 85, one point and Netflix:
P/CF 147, one point.
Adding up the fiscal fitness scores, we
get: Apple 4, Groupon 0, Zillow 3, and Netflix
0.
How do you use these scores? Obviously,
higher is better, but both three and four point positive scores reflect
reasonably strong financials. Positive scores of one or two are marginal
and zero or negative scores signal high risk.
That said, high financial fitness scores don’t mean that you’ll make
money owning a stock. Many other factors come into play. Conversely, not
every negative score stock will crash and burn. Consider the fiscal
fitness score as another tool for your stock analysis toolbox.
revised
5/14/14 |