Over the past few weeks, I've taken the liberty of conducting an autopsy on wearable computer maker Xybernaut
So on to it. For readers who are not yet up to speed on the story, what we're doing here is using Xybernaut as a case study in red flags: signs that an investor can recognize when wariness is called for before buying into a company. We started with "Requiem for Xybernaut," which highlighted the most obvious signs: continual release of news "fluff," rising sales unaccompanied by rising profits, and heavy issuance of new shares that dilute existing shareholders. Then, in "When Red Flags Are Waving," we looked at four other, somewhat harder-to-discern warning signs.
Today, we're going counterintuitive. One of Xybernaut's greatest strengths as a company, as related to me in more stock-speculator-authored emails than I can count, was its clean balance sheet, totally devoid of long-term debt. Now ordinarily, a company's lacking debt is a good thing, which is what makes this so tricky. No debt logically means no risk of not being able to repay debt, which means, one would think, no risk of bankruptcy.
Yet as revealed in a press release yesterday, Xybernaut does now risk bankruptcy. If investors are to learn from their experience with this company, they need to understand how that happened. And to do that, they need to shift their attention from the company's balance sheet (which Xybernaut, as companies almost uniformly do, included with every earnings release) to the cash flow statement (which Xybernaut, like all too many companies, routinely declined to provide with its earnings release).
In a debt-free company, the balance sheet presents the company's best side. Without coming right out and saying it, the company tells you: "We've got no debt. We're not in any trouble. Now stop asking questions."
But an investor shouldn't stop asking questions there. Whether they release the information in a press release or not, all companies must show their cash flow statements in quarterly filings with the Securities and Exchange Commission. And on Xybernaut's cash flow statement, an investor could see that while the company had no long-term debt, it did have significant recurring expenditures -- bills coming due that needed to be paid in the short term.
Of course, lacking positive cash flow (also shown on the cash flow statement), the only way the company could pay these bills was by issuing new shares to raise cash. Xybernaut's problem now is that when it failed to timely file its Form 10-K with the SEC, the issuance of new shares became more difficult. If the company is not able to resume such issuances, cash from operations will not be enough to pay its short-term debts. At that point, the company may become insolvent and may need to file for bankruptcy.
Fool contributor Rich Smith has no position, short or long, in Xybernaut.
