Fiscal Fitness First
Whether you’re a value investor or chasing hot growth
stocks, your best candidates are profitable stocks with strong balance
sheets. These stocks can fund growth internally without having to raise
additional cash. Here’s why that’s important.
Firms needing to raise cash have two
choices: They can either sell
additional shares or they could borrow
the needed cash. Both are bad for shareholders. Selling shares
hikes the number of shares outstanding, cutting per-share earnings,
which is the number used to value stocks. Adding debt increases
operating costs, which also shrinks earnings.
Here are four quick tests that you could use to evaluate
your stocks financial strength, which I call “fiscal fitness.” You can
find the needed data on Morningstar (www.morningstar.com)
as well as other financial sites. I’ll check the scores for Home Depot
(ticker HD), Broadcom (AVGO), Lulu Lemon (LULU) and Netflix (NFLX) using
Morningstar to demonstrate the process. For each of the four tests,
award -1, 0, or +1 points as described below.
To start, from Morningstar’s home page, enter a
ticker symbol; then scroll down past the “Financials” section,
Financials Data,’ and then “Key
Too Much Debt?
Leverage Ratio is the best debt measure. A
leverage ratio of one means no debt and the higher the ratio, the
higher the debt. Ratios below 2.5 signal low-debt, and ratios above 5.0
correspond to high-debt. 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. Morningstar labels the
Leverage Ratio "Financial Leverage." Here are
Morningstar's Financial Leverage values
and our resulting point values for
each of the four stocks:
Home Depot: FL =
17.7 and points = 1, Broadcom:
FL = 2.5 and points
= 0, Lulu Lemon: FL =1.2
and points = 1, Netflix: FL = 5.1
and points -1.
Cash on Hand?
Use the Quick Ratio which compares available
cash to current liabilities to
determine if a firm has enough cash on hand to pay
its current bills. Ratios are above one when cash exceeds current
liabilities , and vice-versa. Score one point for ratios above 1.0, and
subtract one for ratios below 1.0.
Home Depot: Quick Ratio =
0.4 and points
= -1, Broadcom: QR =3.6
and points =1, Lulu Lemon: QR= 3.3
and points =1, Netflix:
QR= 0.3 and points =
Firms must be profitable to self-fund growth.
Use profitability gauge Return on Assets (ROA), which compares
net income to total assets. Positive values reflect positive earnings
and vice versa. Score one point for ROAs above 10, zero for positive
values below 10.0, and subtract one point for negative ROAs.
Home Depot: ROA =19.2
and points = 1, Broadcom:
ROA =1 and points=
0, Lulu Lemon: ROA =18.3
and points = 1,Netflix:
ROA = 3.0 and points= 0.
Cash Flowing In or Out?
sometimes allows firms to
appear profitable when in fact; cash is flowing out, rather than
into their bank accounts. Operating cash flow (OCF),
is positive when cash flowed in vice-versa. Add one point for positive
values and subtract one point for negative numbers.
Home Depot: OCF was
positive and points= 1, Broadcom:
OCF was positive and points = 1, Lulu Lemon:
OCF was positive and points = 1,
Netflix: OCF was negative
so points = -1.
Adding up the fiscal fitness scores, we get: Home Depot = 0, Broadcom =
2, Lulu Lemon = 4 and Netflix = -3. Positive scores reflect reasonably
strong financials, but many other factors come into play in determining
whether you’ll make money owning a stock. Consider the fiscal fitness
score as another tool for your stock analysis toolbox.