In the past month or two, investors have gotten more comfortable with J.C. Penney's (JCPN.Q) turnaround plan. A theme running through the company's earnings report and conference call this week was that J.C. Penney is "back," and the turnaround is on track.

Indeed, it looks like J.C. Penney is starting to make real progress in its quest for sales and margin growth. It's likely to take a big step forward during the holiday season, when it's more important than ever to offer big eye-catching discounts -- something the company didn't do last year.

J.C. Penney is finally reversing its big sales decline.

However, J.C. Penney is not in the clear, yet. I have never doubted that the company would eventually reverse its recent track record of sliding revenue and gross margin. The problem is simply that J.C. Penney is very far from the breakeven line, and it has been burning cash rapidly. In order to avoid bankruptcy, the company needs not just improvement, but rapid improvement.

Another quarter of burning cash
The big risk for J.C. Penney shareholders is the company's negative cash flow. In the third quarter, the company used $737 million in its operations due to its substantial operating loss and seasonal inventory build for the holidays. It also incurred capital expenditures of $161 million, for total free cash flow of -$898 million. This was partially offset by $33 million of proceeds from selling non-core assets.

For the full year, J.C. Penney has now recorded operating cash flow of -$2.2 billion. After $814 million of capital expenditures, J.C. Penney's free cash flow is around negative $3 billion! This is a stunning number that's basically unprecedented in the retail industry.

J.C. Penney's guidance calls for liquidity of more than $2 billion at the end of the fiscal year, up from $1.71 billion at the beginning of this month. This implies that the company will generate significant free cash flow in the fourth quarter. This should be very manageable, considering that J.C. Penney posted free cash flow of more than $400 million in last year's fourth quarter, just as the company was hitting rock bottom.

The 2014 cash problem
The real problem for J.C. Penney is what happens during 2014. Even if the company ends this year with over $2 billion of liquidity, the fact remains that J.C. Penney burned $3 billion of cash in the first nine months of 2013. A similar performance next year would obviously cause the company to run out of cash mid-year.

There are a few factors that should lead to significantly better cash flow next year. First, while J.C. Penney will have spent nearly $1 billion on capex by the end of 2013, the company plans to slash capital spending to $300 million next year.

Second, J.C. Penney is planning to end 2013 with more than $500 million of additional inventory compared to the beginning of the year. This has been part of a plan to ensure better availability of merchandise in stores, particularly for basics. Adding this inventory has been a drag on cash flow, but it should not recur in 2014.

Third, the company will hopefully be generating sustained sales and margin improvements next year. This is the biggest wildcard, but the improvement in operating losses could be significant once J.C. Penney finishes clearing out unwanted inventory, which has been weighing on gross margin.

With these three "levers," J.C. Penney should be able to cut its negative free cash flow by half next year, and maybe even a little more. However, if the company uses $1.5 billion in the first nine months of 2014 (half of the year-to-date cash burn), it will be dangerously short of liquidity entering the holiday season. J.C. Penney would also have more work to do in 2015 just to reach breakeven on a cash flow basis.

Beyond risky
While I expect J.C. Penney to start recovering sales in the current quarter and moving into 2014, that does not mean it will be a good investment. J.C. Penney has used $3 billion in cash this year, and it's almost certain to burn more cash next year. To avoid running into liquidity trouble again in 2014 or 2015, sales will need to bounce back quickly.

So far, that's not happening; the pace of improvement has been quite modest. Until J.C. Penney can show that customers are rapidly returning to their former shopping habits, investors should stay away.