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.