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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

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