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Detecting potential busted cash burners entails comparing a
company’s cash flow to its working capital. Let’s define those terms
first.
Cash Flow
A company could be burning cash, meaning that it is spending
more cash than it takes in (negative cash flow), even though it reports
positive earnings quarter after quarter.
To illustrate, assume that Company A reports a $1,000 sale to
Customer B. Further, assume that Company A logs the $1,000 order as
shipped, but Customer B hadn't paid for the goods by the end of the
quarter (the $1,000 unpaid bill is added to accounts receivables).
Following the rules, Company A records the $1,000 as a completed
sale, deducts the product cost and other expenses, and logs the
difference, say $200, as net income.
Company A showed the $200 profit on its income statement, but
since it received no cash from the customer, it actually spent $800 in real
cash. Consequently its cash flow, more specifically, its operating cash
flow, was a negative $800.
Let’s modify that scenario and assume that Customer B did pay
before the books were closed. But to get the best prices, Company A ordered
enough materials to build two of the products, say $600 worth. So
Company A has an extra $300 worth of materials in its inventory. Assuming
that Company A paid cash for the materials, it ended up with
$100 less in the bank ($200 net income on the product sold less $300 for
extra inventory). So it recorded $200 income on the sale, but its operating
cash flow resulting from the sale was a minus $100.
Finally, assume a third scenario where Customer B paid before
the end of the quarter, but Company A had to buy a new machine costing
$2,000 to produce the product. So Company A’s operating cash flow
was $200, but after shelling out $2,000 in capital expenses, it was, in
fact, $1,800 poorer for the transaction. Free cash flow is accounting terminology
for operating cash flow minus capital expenses (plants and
equipment). In this example, Company A’s free cash flow was a negative
$1,800.
Financially distressed companies will probably cut capital expenses
to the bone, so we’ll use operating cash flow to analyze potential
busted cash burners.
Working Capital
Examining a company’s cash flow tells only half the story. You
must also measure its financial resources, termed working capital, to
determine if it’s a potential busted cash burner. Working capital is the
company’s current assets minus its current liabilities. In accounting
terminology, current refers to assets and liabilities that are short-term
in nature.
Current assets include cash and other assets such as inventories
and accounts receivables. It doesn’t include nonliquid assets such as
buildings, capital equipment, patents, and the like.
Cash includes the cash in the bank plus short-term investments.
Inventory includes finished products ready to be shipped to customers,
raw materials, and partially built products (work in process). Accounts
receivables are the monies owed by customers for goods that have been
shipped, but not paid for.
Current liabilities include unpaid taxes, accounts payables,
short-term debts, and anything else the company will have to pay out
during the next 12 months.
Working capital is simply the current assets minus the current liabilities,
the cash available to run the business. Current ratio is another
term that describes the same information. Instead of subtracting, simply
divide the current assets by the current liabilities to determine the current
ratio.
Cash Burner Analysis
You can do the analysis using balance sheet and cash flow data
offered by a variety of financial sites. However, Morningstar compiles
the data into the needed format. Especially important, Morningstar displays
the trailing twelve-month’s (TTM) operating cash flow, a figure
vital to the analysis.
It shouldn’t take you longer than a minute or two to complete the
entire busted cash burner analysis using Morningstar’s Financials display
(Figure 10-1).Morningstar’s balance sheet breakdown lists cash
and other current assets on separate lines. Start by adding those two
items together to compute the company’s current assets. Then calculate
the working capital by subtracting the current liabilities from the current
assets. Using Morningstar’s terminology:
Working capital = cash plus other current assets minus current
Liabilities
Next, estimate the likely operating cash flow for the current year.
Morningstar lists the operating cash flow for the last three fiscal years in
addition to the TTM amount. Usually, the TTM number is a good estimate.
However, you may need to modify it if the historical cash flows
are inconsistent from year to year. For instance, say that the last three
fiscal years’ cash flows are –50, 50, and –20, respectively and that the
TTM cash flow is 30. That much inconsistency makes the TTM number
suspect. You have to exercise judgment in those instances, and I’d probably
assume a zero cash flow value in that example.
Based on the working capital and cash flow values that you
come up with, each company that you analyze will fall into one of four
categories:
1. Cash flow positive and working capital positive
2. Cash flow positive and working capital negative
3. Cash flow negative and working capital positive
4. Cash flow negative and working capital negative
Cash Flow Positive and Working Capital Positive
This is the best result, and in fact, you wouldn’t go wrong requiring
that every stock you buy meet this requirement. The company is generating
positive cash flow from its operations, and it has positive
working capital. These companies already have enough working capital
to pay their bills, and they are consistently adding more cash to the pile.
Security software maker Symantec’s December 2001 financials
(Figure 10-1) illustrate the point. The company had $1,187 million in
cash and another $274 million in other current assets on its balance
sheet. Subtracting the $558 million current liabilities left Symantec with
working capital of $903 million. Further, Symantec generated $415 million
in TTM operating cash flow. Comparing the TTM cash flow to the
last three fiscal years shows the TTM number to be reasonable.
There may be other reasons why Symantec’s shares might not
have been a smart buy, but the company wasn’t a busted cash burner
candidate, either.
Cash Flow Positive and Working Capital Negative
These companies are typically former cash burners that have
turned the corner and are now generating cash. However their liabilities
outdistanced their assets when they were burning cash. You must determine
if their now-positive cash flow is sufficient to overcome their
working capital deficit.
Oil drilling instrument maker Global Technovations offers a
good example. As of December 31, 2000, Global’s balance sheet
showed current assets of $14 million compared to $31 million in current
liabilities, so in terms of working capital, it was $17 million in the hole.
The company posted positive TTM operating cash flow, but it
only amounted to $2 million, not much compared to the $17 million deficit.
The company would have still been $13 million in the hole, even if
you had assumed that its cash flow would double to $4 million in 2001.
Global filed bankruptcy in December 2001.
As a rule of thumb, the estimated annual operating cash flow
should at least equal the working capital deficit.
Cash Flow Negative and Working Capital Positive
Most cash burners that you encounter will have positive working
capital. In these instances, you’ll need to estimate how long the company
can continue operating at its present burn rate before it runs out of cash.
The best way to get a handle on that is to convert the TTM operating
cash flow to a monthly burn rate (divide by 12) and then compare
the burn rate to the working capital. For example, the company has a 10
months’ supply of cash if it’s burning $10 million monthly and has $100
million in working capital.
How much is enough? There’s no hard and fast rule, but a company
probably has a good shot at surviving if it has enough cash to last
at least two years. If the company’s business plan makes sense, it’s likely
to attract more capital, or better yet, become cash flow positive in that
timeframe.
Conversely, firms with less than 12 month’s working capital
are in dangerous waters unless they can raise additional funds in short
order. To illustrate, consider two examples—Calico Commerce and
DoubleClick:
E-commerce software maker Calico Commerce had burned $50
million in the four quarters ending in June 2001, around $4 million per
month. With current assets of only $14 million, Calico had only enough
working capital to last around three or four months.
Calico was very much a busted cash burner candidate, and in December
2001, Calico made a deal to file bankruptcy and then be acquired
by Peoplesoft for a grand total of $5 million. Calico’s shareholders netted
around $0.14 per share in the deal, a long way from the $60 that Calico
shares had fetched 18 months earlier.
Internet advertising company DoubleClick burned $8 million in
the four quarters ending September 30, 2001. However the dot-com survivor
had $186 million in the bank, plus another $501 million in other
current assets. Since its current liabilities amounted to only $142 million,
DoubleClick’s working capital totaled $545 million, enough to last
68 years, at DoubleClick’s then current burn rate.
With that much working capital, DoubleClick was bound to figure
out how to make money before it ran out of cash.
Cash Flow Negative and Working Capital Negative
Companies in this condition are as good as gone, and normally
you wouldn’t find many firms in such dire straights. However they were
plentiful in 2000 and 2001.
E-learning infrastructure supplier Caliber Learning Network is
one such example. According to its March 2001 report, the company had
burned $22 million in the previous four quarters, leaving it with a $20
million working capital deficit. The firm filed its March report on May
22, 2001, and filed bankruptcy three weeks later.
Simple Analysis Is Good Enough
This simple analysis assumes that the TTM cash flow burn rate
will continue into the future, and that each company’s working capital
will be completely converted to cash in time to pay its operating expenses.
In practice, a firm running close to the edge will figure out how
to reduce its cash burn rate, but conversely, not all of its working capital
will convert to cash. Not all of its inventory will be sold, and not
all of its accounts receivables will be collected. All in all, the assumption
errors tend to be self-canceling, and the estimate is close enough
for our purposes.
Some Will Survive
Not all busted cash burner candidates will file bankruptcy. Some
will find additional financing, and others will be acquired.
You can do more research to identify likely survivors. Start by
checking the news for each company. Firms that have found additional
funding will say so in a press release.
For instance, wireless telecommunications product distributor
Airgate PCS was a persistent cash burner. The company burned $41 million
in the 12 months ending September 30, 2001. Worse, the company’s
working capital was in the hole by $6 million. However, Airgate
had a commitment from Lehman Brothers for loans up to $98 million,
which Airgate’s management considered sufficient to fund the company
through 2002, when the company expected to achieve breakeven operating
cash flow.
If you don’t find out anything by checking the news, you could
continue your research by reviewing each company’s SEC reports, but
you should first decide whether the time wouldn’t be better spent locating
a more promising candidate. | 
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