Five ways to stress test your stocks

Stress testing banks is all the rage. But what about other sectors? Here are five ways to test your shares to see how they'd cope with another big dip.

1. Check for debt distress

Like a homeowner with a mortgage, a firm with debt faces two big challenges: repaying it, and servicing the interest. An investor should look, as a minimum, at three key ratios. First there's gearing.

A common way to calculate it takes a firm's interest-bearing debt as a percentage of its shareholders' funds (or 'equity'). If interest-bearing debt is £100m and equity is £200m, gearing is 50%. Some sectors (utilities, for example) can handle high gearing. But beware a firm with high gearing relative to its sector.

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Then there's interest cover. This is the number of times profits before interest and tax (PBIT) covers the interest charge. So if PBIT (also known as EBIT, or operating profit) is £100m and the interest charge (just below it) is £10m, interest cover is ten times. That's one target a firm needs to hit if wants to get an AAA rating from a credit-rating agency. Very low, or rapidly falling, interest cover is a red flag.

The third test is cash cover. This is a similar idea, only using the cash flow statement. It's the number of times a firm's cash flow from operations covers the last year's interest payment. The higher the better. A big gap between interest cover using the profit and loss account and the same calculation done using cash flow is another sign of looming debt distress.

2. Operational leverage can be lethal

A constant bugbear for banks, airlines, hotels and the like is the relationship between fixed costs the big two tend to be property and people and variable costs, such as raw materials, light and heat. Firms with a high ratio, and therefore high 'operational gearing', can get caught out fast in a downturn.

For example, a firm might have annual sales of £100m, fixed costs of £80m and variable costs of £10m. That's a £10m profit. Say sales drop 10% to £90m. Fixed costs will stay at around £80m, but variable costs will drop by, say, 10% too, to £9m. Now the overall profit is just £1m (£90m £80m £9m). So a 10% drop in sales has triggered a 90% fall in profits. Sure, a firm might be able to cut fixed costs by moving to a cheaper building or firing staff. But both are time-consuming and costly. For an investor, better to steer clear in a downturn.

3. Watch out for buried bombs

As BP shows, the once mighty can fall far and fast. For years now the firm will have to disclose details of clean-up costs running into billions of dollars, both incurred and planned. But where will investors find this information? The publicity around BP and its sheer size mean these costs will have to be fairly transparent its annual financial statements will be peppered with references. But with smaller, less high-profile firms, you have to dig around yourself. One note towards the back of the accounts is worth a read. It describes 'contingent liabilities' uncertain obligations that may turn into trouble. Think litigations claims, or decontamination costs and the like.

Also watch the fixed asset note (or further forward in the profit and loss account, check for 'exceptional' items) for big impairments. As an economy stalls, past acquisitions and investments start to look poor value. Firms have to take 'impairment' hits to profit where long-term valuations (on buildings, plant, or investment in other companies, for example) start to fall. Highly acquisitive firms, or those that grew most rapidly before a downturn, are most at risk.

4. The working capital trap

Highly profitable companies can still go bust. When an economy slows, stock levels can soar (as firms keep ordering just as customers tighten their belts) and receivables can shoot up as customers take longer to pay. On top of that, a firm (usually a small one) may buckle to pressure from its suppliers to pay them early. So keep an eye on balance-sheet stock, debtors and creditors. A sharp rise in stock and receivables in particular, without a corresponding rise in sales, can be an early sign of big cash-flow trouble.

5. Altman's Z-score

Back in the 1960s, Dr Edward Altman devised a combined test of financial strength for non-financial firms. It's a bit fiddly, and the data isn't widely published (if you can pick out certain key figures from a set of financial statements there's a calculator at www.creditguru.com/CalcAltZ.shtml). It combines five key financial ratios into a single score. The higher the Z-score, the stronger the firm above three is seen as relatively safe.

So, who isn't looking stressed?

One blue-chip name that passes with flying colours is household goods firm Reckitt Benckiser (LSE: RB). Its second-quarter results missed City hopes. But its £2.5bn acquisition of condom maker SSL looks well timed and it carries little debt and generates lots of cash. Another good bet is Compass Group (LSE: CPG), the world's biggest contract caterer. It boasts dividend cover of 2.3 times. While gearing is much higher than Reckitt Benckiser at just under 40%, interest cover is a healthy eight times and cash flow is strong.