With the market getting bumpy, it’s time to start paying more attention to fundamentals, especially, financial strength. Firms strong in that department won’t have to dilute earnings by selling more shares or borrowing to fund operations.
Here are five quick tests that you could use to evaluate your stocks financial strength, which I call “fiscal fitness.” I’ll describe the tests using Morningstar data, but you could find the same information on other sites.
I’ll check the scores for CarMax (NYSE:KMX), Lululemon (LULU), Roku (ROKU) and T-Mobile (TMUS). To start, from Morningstar’s home page (Morningstar.com), enter a ticker symbol; then click on Financials.
Profitable firms are best able 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, and subtract one point for negative ROAs. Here are the ROA and point values for each stock:
CarMax: 4.7% = 0, Lululemon: 23.4% = 1, Roku: -3.6% = -1, T-Mobile: 4.3% = 0
Cash on Hand?
Use the Quick Ratio (cash vs. liabilities) to determine if a firm has enough cash on hand to pay 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.
CarMax: 0.1 = 0, Lululemon: 1.2 = 1, Roku: 2.5= 1, T-Mobile 0.4 = 0
Bookkeeping rules sometimes make firms appear profitable when in fact; cash is flowing out, rather than into their bank accounts. Scroll down to the bottom of the Financials page to see the cash flow numbers. “Operating cash flow” is the cash that flowed into, or out of, a firm’s bank accounts resulting from its basic operations. Obviously, cash flowing in is better than cash flowing out. Using the TTM (trailing 12 months) values, add one point for positive values and subtract one point for negative cash flow.
CarMax: 0.0 = 0, Lululemon: 0.6 = 1, Roku: 39.1 = 1, T-Mobile 5.4= 1
Free Cash Flow?
Free Cash Flow, operating cash flow minus capital expenditures, is excess cash that a firm does not need to fund its basic operations. It could be used to cut debt, fund expansion, raise dividends, etc., all happy events for shareholders. Add one point for positive free cash flows, and subtract one point for negative values.
CarMax: 0.0 = 0, Lululemon: 0.3 = 1, Roku: 6.9= 1, T-Mobile: -1.8 = -1
Too Much Debt?
Financial Leverage is the best debt measure. Find it on the Operating Performance page. A value 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 translate to high-debt. Award one point for ratios below 2.5, and subtract one point for ratios above 5.0.
CarMax: 5.6 = -1, Lululemon: 1.4 = 1, Roku: 1.9 = 1, T-Mobile: 2.9 = 0
Adding up the fiscal fitness scores, we get: CarMax = -1, Lululemon = 4, Roku = 2 and T-Mobile = 0. Any positive score reflects okay financials, but the higher the better. Keep in mind that besides for financial strength, many other factors come into play in determining whether you’ll make money owning a stock.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.