>>Convertible worries
Another balance sheet lesson involves convertible notes. Some are more convertible to stock than others, and the ones that aren't could spell trouble for shareholders.
Take ONI Systems (ONIS: news, chart, profile). San Jose, Calif.-based ONI has turned the heads of some investment banks recently. The company sells the majority of its equipment in the fastest-growing networking niche - metro-optical. Analysts at Credit Lyonnais Securities recently upgraded ONI's shares, citing sales growth expectations of 37 percent from 2003 to 2005.
But a large potential problem still looms for ONI. The company borrowed $300 million a few years ago, and issued a convertible note to pay for it. The note was issued when the stock was more than $90 a share. With shares now at $5.60 a share, owners of the convertible debt are unlikely to ever convert it to stock. It means the massive debt will likely show up as "real" debt that ONI must pay back by October 2005.
You can find details of the convertible note on ONI's balance sheet, with even more details in the company's government filings.
In general, investors need to spend much more time becoming familiar with balance sheets, not just income statements, says Chris Bonavico, who oversees $250 million in two funds for Transamerica Investment Management.
He adds that investors rely too heavily on price-to-earnings ratios and other measures of earnings when choosing stocks. Instead of calculating P/Es, investors should spend their time getting a handle on a company's cash flow.
Bonavico suggests you treat every one of your stocks as if you owned the entire business. To determine what the cash flow is, ask how much money can be taken out of the business as profit, while still maintaining the company's growth. If the "free" cash isn't increasing, it's not a good business to own.
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