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Use Cash Flow to Spot Bankruptcy Candidates
Cash flow analysis

Consolidated Freightways made headlines last week when it filed bankruptcy and ceased operations. According to news reports, Consolidated’s shareholders were likely to lose their entire investment. 

We’ve heard a lot recently about investors being duped by accounting fraud. But Consolidated simply ran out of cash to pay its bills. Any investor with access to the Internet could have used its cash flow statements to determine that Consolidated was risky business months ago. 

Analyze Cash Flow
Consolidated was a cash burner in recent years, meaning that it used more cash than it made. Because of the way accounting is done, it’s possible for firms to appear profitable, but lose money on a cash basis. That is why many investors pay more attention to cash flow than to reported earnings.

Any firm can have a bad year, but habitual cash burners must replenish their cash by borrowing or selling more shares to stay afloat. Both approaches reduce per-share earnings, and consequently are bad news for existing shareholders, even in the best of times. Therefore, some investors shun cash burners even if solvency is not an issue.

Cash Burn Rate vs. Working Capital   
You can find out if a cash burner is a bankruptcy candidate by comparing its “burn rate” to its working capital. Burn rate is the amount of cash used each month, and working capital is the money available to finance day-to-day operations (current assets minus current liabilities).

You can estimate the monthly burn rate by dividing a firm’s recent 12 month’s cash flow by 12. For instance, the burn rate was $10 million per month if the firm’s cash flow amounted to a negative $120 million during the most recent 12 months ($120 million divided by 12). 

The next step is to estimate how long the working capital will last if the firm continues burning cash at the same rate. For example, it has a six-month’s supply of cash if it’s burning $10 million monthly and has $60 million working capital ($60 million divided by $10 million).

Morningstar's User-Friendly Cash Flow Report  
You can find the needed information to do the analysis on many websites, but Morningstar’s Financials report presents the data in a particularly user-friendly format. Get there from Morningstar’s mainpage (www.morningstar.com) by getting a quote and then selecting the Financials report (5 Years). 

Scroll down to the Cash Flow data. Morningstar displays three cash flow data items for the last four reported quarters (trailing 12-months) and for each of the last three fiscal years. Use the trailing 12-months figures to estimate future cash flows unless they are clearly inconsistent with the older results.

The first item, operating cash flow, is the money that flowed in or out of the firm’s bank accounts from its main operations.

Next is capital spending, the cash used to acquire plants and equipment. Finally, free cash flow is operating cash flow less capital spending.

Solvency issues aside, many investors require candidates to show strong positive operating cash flow. As a rule of thumb, the operating cash flow should exceed the net income for the same period. Some investors are even more stringent and also require strong positive free cash flow. At a minimum, you’d be well served by disqualifying candidates reporting persistent negative free cash flow.

Consolidated Was Burning Cash
Morningstar reported Consolidated’s operating cash flow as a negative $34 million for the trailing twelve months ending in March 2002. Adding capital spending drove the free cash flow total to a negative $77 million. However, I usually use the operating cash flow for this analysis because cash-poor firms will likely curtail capital spending. On that basis, Consolidated was burning cash at the rate of $2.8 million monthly ($34 mil divided by 12).

You can determine Consolidated’s working capital by adding its cash to its “other current assets,” and then subtracting its current liabilities. Doing that calculation using Consolidated’s March quarter numbers yielded a negative $21 million ($13 million cash plus $404 mil other current assets minus $438 mil current liabilities).

Yikes, Consolidated was already out of cash! In other words, Consolidated was technically insolvent. You would have found the same result if you had done the analysis earlier in the year when Consolidated’s 2001 year-end figures became available.

Consolidated last reported positive working cash flow ($19 million) as of September 30, 2001. You would have determined that Consolidated had about seven months cash supply if you had done the analysis last year using its September results and assuming that it was burning $2.8 million per-month back then.

How Much is Enough?
How much working capital is enough? There is no hard and fast rule, but less than a year’s supply clearly signals danger. Probably a two-year or longer supply is not a cause for alarm, at least in terms of bankruptcy. Many firms have a good shot at solving their problems with that much time.

Obviously, not every firm that doesn’t meet these requirements will file bankruptcy. Some will manage to raise the funds required to keep operating, and others will be acquired.

Performing this simple analysis will flag many firms with a high bankruptcy risk. But it doesn’t assure that a heavily indebted firm is generating enough cash to service its debts. Consequently, it’s best to avoid unprofitable firms with total debt to equity ratios of 0.4 or higher unless you’re willing to perform a detailed financial strength analysis. 
published 9/8/02

 

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