If you believe in the old adage, "it takes money to make money," then you can grasp the essence of cash flow and what it means to a company.

The statement of cash flows reveals how a company spends its money (cash outflows) and where the money comes from (cash inflows). We know that a company's profitability, as shown by its net income, is an important investment evaluator. It would be nice to be able to think of this net income figure as a quick and easy way to judge a company's overall performance. However, although accrual accounting provides a basis for matching revenues and expenses, this system does not actually reflect the amount the company has received from the profits illustrated in this system. This can be a vital distinction.

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Difference Between Earnings and Cash

Individual Investor, Jonathan Moreland provides a very succinct assessment of the difference between earnings and cash. He says "at least as important as a company's profitability is its liquidity - whether or not it's taking in enough money to meet its obligations. Companies, after all, go bankrupt because they cannot pay their bills, not because they are unprofitable. Now, that's an obvious point. Even so, many investors routinely ignore it. How? By looking only at a firm's income statement and not the cash flow statement."

The Statement of Cash Flows

Cash flow statements have three distinct sections, each of which relates to a particular component - operations, investing and financing - of a company's business activities. For the less-experienced investor, making sense of a statement of cash flows is made easier by the use of literally-descriptive account captions and the standardisation of the terminology and presentation formats used by all companies:

Cash Flow from Operations

This is the key source of a company's cash generation. It is the cash that the company produces internally as opposed to funds coming from outside investing and financing activities. In this section of the cash flow statement, net income (income statement) is adjusted for non-cash charges and the increases and decreases to working capital items - operating assets and liabilities in the balance sheet's current position.

Cash Flow from Investing

For the most part, investing transactions generate cash outflows, such as capital expenditures for plant, property and equipment, business acquisitions and the purchase of investment securities. Inflows come from the sale of assets, businesses and investment securities. For investors, the most important item in this category is capital expenditures (more on this later). It's generally assumed that this use of cash is a prime necessity for ensuring the proper maintenance of, and additions to, a company's physical assets to support its efficient operation and competitiveness.

Cash Flow from Financing

Debt and equity transactions dominate this category. Companies continuously borrow and repay debt. The issuance of stock is much less frequent. Here again, for investors, particularly income investors, the most important item is cash dividends paid. It's cash, not profits, that is used to pay dividends to shareholders.

A Simplified Approach to Cash Flow Analysis

A company's cash flow can be defined as the number that appears in the cash flow statement as net cash provided by operating activities, or "net operating cash flow," or some version of this caption. However, there is no universally accepted definition. For instance, many financial professionals consider a company's cash flow to be the sum of its net income and depreciation (a non-cash charge in the income statement). While often coming close to net operating cash flow, this professional's shortcut can be way off the mark and investors should stick with the net operating cash flow number.

While cash flow analysis can include several ratios, the following indicators provide a starting point for an investor to measure the investment quality of a company's cash flow:

Operating Cash Flow/Net Sales

This ratio, which is expressed as a percentage of a company's net operating cash flow to its net sales, or revenue (from the income statement), tells us how many dollars of cash we get for every dollar of sales.

There is no exact percentage to look for but obviously, the higher the percentage the better. It should also be noted that industry and company ratios will vary widely. Investors should track this indicator's performance historically to detect significant variances from the company's average cash flow/sales relationship along with how the company's ratio compares to its peers. Also, keep an eye on how cash flow increases as sales increase; it is important that they move at a similar rate over time.

History of Free Cash Flow

Free cash flow is often defined as net operating cash flow minus capital expenditures, which, as mentioned previously, are considered obligatory. A steady, consistent generation of free cash flow is a highly favorable investment quality - so make sure to look for a company that shows steady and growing free cash flow numbers.

For the sake of conservatism, you can go one step further by expanding what is included in the free cash flow number. For example, in addition to capital expenditures, you could also include dividends for the amount to be subtracted from net operating cash flow to get to get a more comprehensive sense of free cash flow. This could then be compared to sales as was shown above.

As a practical matter, if a company has a history of dividend payments, it cannot easily suspend or eliminate them without causing shareholders some real pain. Even dividend payout reductions, while less injurious, are problematic for many shareholders. In general, the market considers dividend payments to be in the same category as capital expenditures - as necessary cash outlays.

But the important thing here is looking for stable levels. This shows not only the company's ability to generate cash flow but it also signals that the company should be able to continue funding its operations.

Comprehensive Free Cash Flow Coverage

You can calculate a comprehensive free cash flow ratio by dividing the comprehensive free cash flow by net operating cash flow to get a percentage ratio - the higher the percentage the better.

Free cash flow is an important evaluative indicator for investors. It captures all the positive qualities of internally produced cash from a company's operations and subjects it to a critical use of cash - capital expenditures. If a company's cash generation passes this test in a positive way, it is in a strong position to avoid excessive borrowing, expand its business, pay dividends and to weather hard times.

The term "cash cow," which is applied to companies with ample free cash flow, is not a very elegant term, but it is certainly one of the more appealing investment qualities you can apply to a company with this characteristic.

The Bottom Line

Once you understand the importance of how cash flow is generated and reported, you can use these simple indicators to conduct an analysis on your own portfolio. The point, like Moreland said above, is to stay away from "looking only at a firm's income statement and not the cash flow statement." This approach will allow you to discover how a company is managing to pay its obligations and make money for its investors.

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