Far from being luck, it comes down to listening and looking intently at the company… Specifically, I’ve devised three indicators for you that can help you find the next share to go bust, before you lose your entire investment on it.
Bankruptcy Indicator #1 – Taking a deeper look…
Three signs that the 'turnaround' stock you’re holding could go bust
Listed companies can’t just outright lie to you. They have to tell you the truth of what’s going on with their finances.
But they tend to try and hide this truth deep in hundred page reports…
In Highveld Steel’s case the truth about its financial situation was buried in the 170 page long annual report Highveld released for its 2013 financial year. The note said the following:
“We draw attention to the going concern paragraph in note 1.1 to the financial statements which indicates that the Company is using committed loan facilities that are payable on 31 December 2014 and is trading in an environment where there are threats to production stability and market demand for the Company's products.
Note 1.1 also indicates that these conditions, along with other matters, indicate the existence of a material uncertainty which may cast significant doubt on the Company's ability to continue as a going concern.”
Read that again – “the existence of a material uncertainty which may cast significant doubt on the Company’s ability to continue as a going concern.”
If you ever read something in the line of this within a company’s financial report you should know: STAY AWAY.
But as I said – these statements are often hidden deep in these reports, like this one which I found buried on page 170. Fortunately there are also two SHORTCUTS that’ll tell you the same thing…
Bankruptcy Indicator #2 - ‘Interest Cover’
This number tells you how many times a company can pay its interest expenses using the money it makes. Typically you want a company to have an interest cover ratio of two or higher.
You can calculate this number yourself using a company’s earnings before interest and tax (EBIT) divided by its annual interest expenses. Both these numbers will be in the financials for a company.
Think of this number like this: You own a house on which you need to make monthly repayments of R12,000 to the bank. If you earn R30,000 a month your ‘interest cover’ would be 2.5 and you would be fine to pay these every month.
If on the other hand your salary is R15,000 and you still need to make R12,000 repayments your ‘interest cover’ would be only 1.25 and you would struggle immensely to even survive. The same goes for companies.
In Highveld Steel’s case the interest cover ratio has been NEGATIVE since 2010. That means since 2010 the company hasn’t made enough money to cover its interest expenses…
Bankruptcy Indicator #3 – ‘Current Ratio’
This number tells you whether a company can pay all of its creditors in the next twelve months using the cash it has in the bank as well as its stock.
You can calculate it using current assets divided by current liabilities. You’ll find both these numbers on a company’s balance sheet.
So – if a company has a current ratio higher than two it means that it can easily pay all its creditors in the next twelve months. If the number is lower than two – it can’t.
Think of it this way: Let’s say you’ve just lost your job. But you have R100,000 in the bank. For the next twelve months you know you’ll have to pay your home loan wi
th this money – that amounts to R40,000. Your current ratio would be 2.5.
If however you had only R50,000 in the bank and you needed to make repayments of R40,000 your current ratio would be 1.25. The chances of you surviving the next year financially would be slim…
The same goes for a company.
In Highveld Steel’s case the company’s Current Ratio steadily dropped from 2.36 to 2.08, 1.60 and finally to 1.36 between 2010 and 2013.
By 2014 this number hit 1, meaning it had just enough money to cover its expenses for the year. But nothing else. And considering Highveld was still making a loss on operations the company’s bankruptcy was a done deal.
Simply put – if you follow these guidelines it becomes easy to identity a share that’s set for bankruptcy…
Right now there are a bunch of JSE listed shares with flashing warnings lights…
Arcelor Mittal, for instance, is on a negative interest cover and its current ratio has dropped from 2.91 in December 2009 to 1.44 in December 2014. The company is still hanging in there, but unless steel prices increase soon it will be in need of a large rights issue or alternative financing…
In fact, as we speak the company is planning to shut two steel mills and possibly cutting production at its largest operation...
Here’s to unleashing real value
Editor, Red Hot Penny Shares