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Dozens of companies failed in recent years, leaving their shareholders with nothing.
So it behooves us to do our homework to ensure that we’re not holding the next financial basket case. But the last thing most of us want to do is spend hours poring over financial statements.
Here’s the good news: You don’t have to.
I found that a few simple tests would have helped investors avoid most, if not all, of the stocks that went belly up. To develop the tests, I analyzed a bunch of stocks, some in technology, and some not, that filed bankruptcy in 2001 and 2002. Then I compared them to stocks in the same industries that survived and are still in business today.
Put away your calculator
You can apply these tests using readily available data -- and you don’t even need a calculator. I call the stocks that pass these tests “bulletproof stocks.”
The bulletproof tests can be put to work in two ways. You can check the suitability of specific stocks, or you can use the bulletproof formula to come up with financially strong candidates, suitable for further analysis from other perspectives.
Before jumping into the tests, let's lay the groundwork.
This is obvious, but worth saying: All of the companies that I analyzed failed for the same reason. They ran out of cash.
Some were recent startups that were never profitable. That is, either their products cost more to make than their customers paid, or they never sold much to begin with. They started with tons of IPO cash, but failed when they burned through their initial stash.
Others were long-established companies that had built up high debt over the years. They failed when the economy slowed, reducing their cash flow to the point where it couldn’t cover the interest payments.
Don't get singed by the cash burners
With that in mind, I defined six tests that these cash burners can’t possibly meet. I’ll describe each test, and I’ll use women’s clothing retailer Christopher & Banks (CBK, news, msgs) to demonstrate the analysis.
We’ll start by looking at sales data, which can be found on the Company Report for Christopher & Banks.
No. 1: Selling pipedreams?
Many of the companies that went bust had great stories to tell, but never sold much. So my first requirement is that a company must be registering significant sales. Otherwise, they must frequently raise new cash to meet expenses. How much is enough?
Most public corporations count sales in hundreds of millions, if not billions. I set the sales minimum at $50 million to eliminate companies that can’t survive on their own because they’re not selling anything.
You can see the last 12 months’ sales in the “Financials” section of the Company Report. Christopher & Banks easily passed with $386 million in trailing twelve months (TTM) sales.
Required: Minimum $50 million trailing 12 months' sales
No. 2: Cash burners . . . not!
Operating cash flow is the money that moves in or out of a company's bank accounts as a result of its basic operations.
Negative cash flow, meaning cash is flowing out, not in, at the very least signals that further financial scrutiny is required. Simply by insisting on positive cash flow, you significantly reduce your chances of picking a dud in terms of financial health.
You can see a company’s operating cash flow on its cash-flow statement, but because all we’re looking for is positive cash flow, it’s easier to check the price-to-cash flow ratio. The P/CF can only be positive when cash flow is positive. You can see the P/CF ratio by clicking on “More Financial Ratios” in the Fundamental Data section of the Company Report, and then selecting “Price Ratios.” Christopher & Banks P/CF is 13.9, signaling that Christopher & Banks’ cash flow is positive, so it passes.
Required: Positive trailing 12 months' operating cash flow
No. 3: Shenanigans check
The positive cash-flow requirement, in theory, eliminates cash burners. But some companies are creative with their accounting, and cash flow alone is not a foolproof indicator. Requiring that the company reported positive net income, in addition to positive cash flow, helps to assure that the company is, in fact, profitable.
The easiest way to confirm that the company is profitable is by checking the Net Profit Margin figure in the Fundamental Data section of the Company Report. Because profit margin is net income divided by sales, the profit margin will only be a positive number if the company reported positive net income.
Christopher & Banks, with a 10.8% profit margin, passed.
So far, we’ve determined that Christopher & Banks is recording significant sales, is profitable and is producing cash, not burning it. But passing those tests doesn’t mean that Christopher & Banks is generating enough cash to service its debt.
Analyzing a company’s debt-servicing ability is tricky business and doesn’t lend itself to easy shortcuts. So I finesse the problem by sticking with low debtors, so we don’t have to do the financial analysis.
First, we’ll check the company’s cash situation vis-à-vis its immediate debts using both the current ratio and the quick ratio, and then we’ll use the debt-to-equity ratio to rule out companies with high long-term debt.
Required: Positive net income
No. 4: No short-term cash crunch
Current ratio measures a company’s working capital by comparing its current assets, namely cash, accounts receivables (money due from customers) and inventories, with its short-term debt. The ratio exceeds 1 when current assets exceed short-term debt and is less than 1 when debt exceeds assets. Requiring a 1.5 current ratio means that current assets exceed current debt by at least 50%, evidence that the company isn’t facing a looming cash crunch.
To see the current ratio, click on “More Financial Ratios” in the Fundamental Data section of the Company Report, and then select Financial Condition. Christopher & Banks' 6.1 current ratio easily passes the test.
Required: Minimum 1.5 current ratio
No. 5: Watch out for innovative inventory counting
Working capital is called working capital because it’s assumed that both of its non-cash components (receivables and inventories) will convert to cash on a timely basis.
But there’s always a chance that the inventory figures are inflated with obsolete or unwanted products that will never be sold. Quick ratio (QR) is similar to current ratio, except that it counts only cash and accounts receivables, not inventories. Requiring a 1.0 minimum quick ratio assures that the company has enough cash to pay its bills, even without considering inventory.
Quick ratio is listed right below current ratio. Christopher & Banks’ 3.6 QR signals that it is flush with cash and easily passes the test.
Since Christopher & Banks doesn’t face any short-term cash problems, all that’s left to check is its long-term debt.
Required: Minimum 1.0 quick ratio
No. 6: Ax the high debtors
The debt-to-equity ratio compares a company’s long-term debt with shareholder equity or book value. Usually companies with D/E ratios below 0.5 are considered low debt. But that figure can be misleading. Some companies list a portion of their long-term liabilities in balance sheet entries that aren't counted in the D/E ratio. Cutting the maximum acceptable D/E to 0.25 mitigates that problem.
You can see the D/E ratio on the Company Report, which lists Christopher & Banks D/E as “NA” because it doesn’t have any long-term debt. Needless to say, Christopher & Banks passed this test, and thus, qualifies as a bulletproof stock.
Required: Maximum 0.25 debt/equity ratio
Try screening by industry
I constructed a screen using MSN’s Deluxe Screener that searches for stocks meeting all of the bulletproof parameters. The bulletproof tests are very stringent and err on the side of safety. Consequently, many financially strong but high-debt companies, such as General Electric (GE, news, msgs), flunk the test. When I ran it, only 755 stocks qualified. In my view, limiting the field to 700 or 800 candidates is a small price to pay for avoiding the necessity of doing a detailed balance-sheet analysis.
Because the screener can list just 200 stocks, you need to do your searches by industry. For example, here’s a link to a screen listing bulletproof stocks in the Applications Software industry. It's easy to change the Industry Name parameter to see bulletproof stocks in other industries.
I’ve found that the bulletproof test does a good job of eliminating bankruptcy candidates if their bookkeeping is reasonably honest. However, it won’t protect you from those that egregiously misrepresent their financial condition. Also, the bulletproof tests won’t detect otherwise solvent companies that file bankruptcy to avoid crippling lawsuits, such as those associated with asbestos-related claims.
Passing the bulletproof test says the company isn’t a financial basket case. That doesn’t mean that you’ll make money owning its stock. As always, it's a place to start your research. You still have to do your due diligence.
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