One of my earliest lessons as an investor was the realization that cash flow can tell you more about the state of a business than almost any other financial performance figure.
A company's cash flow tells you how much money the business is generating, and cash really is king in business. Without enough cash flowing in, a company cannot invest in its growth initiatives. It cannot pay staff or meet supplier obligations.
Most importantly, a corporation without cash flow has to rely on its investors and shareholders to cover capital spending costs. If it cannot get the money from investors, the company may have to borrow the money.
If this borrowing does not translate into sales growth and cash flow growth, the company could end up in a death spiral where it has to borrow more money to sustain its obligations continually.
A company's cash flow can also give investors a greater insight into how the business is managed. This information could potentially be more important for an investment thesis than a company's cash position overall.
Learning from a company's cash flow
A company's cash flow figures can tell us a lot about the accounting processes its uses to present its financial situation to investors.
A company that reports profits but is not generating positive cash flow from operations warrants further investigation.
Understanding how the company got to the profit figure it is reporting to investors is vitally important in understanding its processes and how they may influence the market's opinion of the enterprise.
A company that continually reports profits, even though the numbers contain a significant amount of adjustments and may not conform to accounting standards, might not be trustworthy. If a business is manipulating its figures to present the best possible image to the market, one has to ask what else is the company doing to change its image?
These tactics might not be illegal, but in my opinion, any business that tries to mislead its shareholders should be avoided.
Capital allocators
A company's cash flow figures can also tell us a lot about management's capital allocation strategy.
Managers that can sensibly deploy capital are rare. The only way to find these individuals is to look at their performance in the past. Understanding how they have deployed capital in previous positions and if they have deployed capital to achieve the best returns for investors is a vital part of the research process. Past performance should never be used as a guide to future potential, but if a manager has a good track record of creating value for their investors, there is a good chance they will continue down this path.
Corporate cash flow figures can be incredibly revealing on this front. If a company is spending a lot of money on acquisitions while building up debt, this is not always a good sign. Neither is it a good sign if a company is borrowing money to repurchase shares. Investors can find these figures by reading through a company's financials or with a quick glance at the cash flow statement.
A cash flow statement can also tell us a lot about a company's working capital requirements. They may provide insight into inventory movements and the possibility of inventory or channel stuffing.
The bottom line
Put simply, a company's free cash flow statement can be one of the most important documents for investors. These statements can provide a great snapshot of a company's financials and financial position. They can also provide insight into management's capital allocation framework and whether or not management is committed to creating value for investors.
Comparing a cash flow statement to a company's profit and loss statement can also be a quick and easy way to highlight any financial irregularities.
