Spot bankruptcy candidates and steer clear

By Harry Domash

The buzz about a possible General Motors bankruptcy reminds us that failure is an option, even for large, brand-name companies.

Even so, few investors do much to analyze a stock's financial strength, mainly because digging into financial statements is a daunting task.

With that in mind, I've devised a simple score sheet for evaluating financial health. Don't worry: No calculator required.

The process entails looking up readily available data and awarding a stock a score of zero or one in seven categories. The higher the score, the stronger the company's finances. Once you get the hang of it, you should be able to score just about any stock in a minute or two.

To be sure, my score sheet won't send the analysts laboring at credit raters, such as Moody's and Standard & Poor's, to the unemployment office. It's a simple gauge intended to alert you when your stock requires an in-depth financial exam. Also, it won't detect instances where management commits serious fraud, such as inventing nonexistent bank accounts.

The score sheet works by identifying debt-heavy firms that may not be generating enough cash to service that debt. I'll demonstrate the process by tabulating scores for chip maker Intel (INTC, news, msgs) and General Motors (GM, news, msgs).

You can find all the needed data in the Key Ratios section of MSN's Financial Results report for each stock. Once there, start by selecting the Financial Condition report. Click here to see Intel's, for instance.

Assets vs. liabilities

First, look at the Book Value/Share figure.

Shareholders' equity is the difference between a firm's assets and liabilities. Book value is shareholders' equity expressed on a per-share basis. For most firms, assets exceed liabilities, making book value a positive number. However, sometimes the reverse is true -- that is, liabilities exceed assets, making the book value negative. While a negative book value doesn't necessarily warn of bankruptcy, it does signal a weak balance sheet.

• Score sheet: Award one point if the book value is positive, zero if it's negative.

Both Intel and General Motors, with positive book values, earned one point in this category.

Total debt

The most widely used debt measure, the Debt/Equity Ratio, compares total debt to shareholders' equity. A zero Debt/Equity Ratio signals negligible debt. The higher the ratio, the higher the debt. There is no defined cutoff between low and high debt, but most would agree that ratios above one reflect high debt, so the score sheet penalizes firms in that category.

• Score sheet: Award one point if Debt/Equity Ratio is less than 1.

Intel's zero D/E earned it a point. On the other hand, General Motors' well-publicized pension and health-care liabilities equate to very high debt, and a D/E ratio greater than 12, so it scores a zero for D/E.

Note: MSN lists the D/E ratio as "NA" for firms with negative book values. Give a zero D/E ratio score to firms in that category.

Current cash

While the D/E measures overall debt, it doesn't evaluate a company's short-term cash situation. That's where the Quick Ratio comes in handy. It gauges a firm's ability to handle its current bills by first totaling cash on hand and accounts receivable (monies owed to the firm by its customers), and then dividing that figure by its short-term liabilities, such as payroll expenses and other current bills.

Quick Ratios below one means that cash plus receivables won't cover its current liabilities. A low QR by itself doesn't mean that a firm is headed for bankruptcy. Most will come up with the needed cash to pay their bills. But, all else being equal, a firm with a high QR is financially stronger than one with a low value.

• Score sheet: Award one point if the Quick Ratio is 1 or higher.

Intel, with a 1.9 Quick Ratio, and a GM, with an even stronger 2.2, each earned one point.

Leverage Ratio reveals all

The Leverage Ratio, which compares total assets to shareholder equity, is a valuable, all-purpose debt check. Sometimes clever accountants hide liabilities on lines of the balance sheet that aren't included in the D/E ratio. But, because it uses total liabilities, regardless of where they're listed, nothing escapes the Leverage Ratio calculation.

A Leverage Ratio of one signals no debt. The higher the ratio, the higher the debt. The average Leverage Ratio of all companies making up the S&P 500 Index ($INX) is around 5, but leverage ratios for banks, because borrowed funds are their inventories, tend to run higher, typically in the 10 to 15 range.

I set the limit to earn a point at 15, which should allow most firms to earn a point in this category.

• Score sheet: Award one point if the Leverage Ratio is less than or equal to 15.

Intel, with a 1 ratio, easily qualified, but General Motors, with a 21 ratio, flunked.

Note: MSN lists leverage ratios for firms with negative book values as "NA." These firms do not earn a point in this category.

Paying the bills

High-debt isn't necessarily a bad thing. There's nothing wrong with borrowing money at 5% if you can reinvest it and earn 10%. The problem comes in when a firm doesn't earn enough cash to make its loan payments.

Many analysts use the Interest-Coverage Ratio to gauge a firm's ability to service its debt. It divides operating income (earnings before deducting interest and taxes) by interest expense. For example, the Interest-Coverage Ratio would be three if the operating earnings were triple the interest payments. While analysts often require minimum ratios of four to qualify for strong credit ratings, I've found that firms with ratios of 2 or higher are usually safe bets.

• Score sheet: Award one point if the Interest Coverage Ratio is 2 or higher.

Intel, with a 7 ratio, easily met this condition and earned one point. However, General Motors, with a 0.5 ratio, flunked this test.

Show me the money

Cash flow, the money that flowed in or out of a firm's bank accounts, is another key financial-health indicator.

Often, because non-cash accounting charges, such as depreciation, deduct from net income, a firm that reported negative income actually earned money when you count the cash. Conversely, some firms that report positive earnings are actually burning cash.

You can review the cash-flow statements to see which way the cash is flowing, but it's easier to check the Price-To-Cash-Flow Ratio in the Price Ratios section of the Key Ratios report. The ratio will be positive when cash flow is positive and vice versa.

• Score sheet: Award one point if the Price/Cash Flow Ratio is a positive number.

Both Intel and General Motors, with positive cash flow ratios, earned one point.

The power of profits

Companies with a profitable operating history are less likely to run into financial problems than chronically unprofitable firms. Return On Assets, which is net income divided by total assets, is a good profitability measure for this purpose. It is listed in the Investment Returns section of the Key Ratios report. Use the five-year average ROA to get a long-term perspective.

I require a minimum value of 2, which is a relatively easy test. Only the weakest firms, in terms of profitability, will flunk.

• Score sheet: Award one point if the 5-year average return on assets is two or greater.

Intel, with a 15 average ROA passed, but GM, with a 0.7 five-year average ROA, flunked.

Domash's stock score sheet
Key Ratios	Intel's rating	Intel's score	GM's rating	GM's score
Book Value/Share	Positive	1	Positive	1
Debt/Equity Ratio	0	1	12+	0
Quick Ratio	1.9	1	2.2	1
Leverage Ratio	1	1	21	0
Interest-Coverage Ratio	7	1	0.5	0
Price/Cash Flow Ratio	Positive	1	Positive	1
Return On Assets	15	1	0.7	0
Total		7		3

Totaling up the points, Intel scored a perfect seven, while General Motors garnered only three points.

I've found that scores of six or seven reflect financially strong firms that make unlikely bankruptcy candidates. Many tech companies, since they haven't been in business long enough to accumulate huge debt, fall into this category. Firms scoring five points are not as strong, but are probably not anywhere close to being a bankruptcy candidate either.

Companies scoring two or below are obvious financial basket cases and should either be sold or analyzed in detail to better determine their staying power.

Firms, such as General Motors, with scores of three or four are in a gray area. They are problematic at best. Risk-averse investors would be well advised to avoid them.

A reminder: Garnering a high financial-strength score means only that a firm isn't likely to fail. It doesn't mean that you'll make money owning its shares.

At the time of publication, Harry Domash did not own or control positions in any of the stocks mentioned in this article. Domash publishes the Winning Investing stock and mutual fund advisory newsletter and writes the online investing column for the San Francisco Chronicle. Harry has two investing books out, the most recent being "Fire Your Stock Analyst," published by Financial Times Prentice Hall.