Warren Buffett (Trades, Portfolio) is famous for his first two rules of investing: "Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1." These rules may seem simple enough on the face of it, but few investors actually follow them.
Buffett’s first two rules are based on the idea that an investor should always look to make investments that are unlikely to result in permanent capital impairment. To put it another way, investors should always seek to invest in stocks that are not likely to go to zero, wiping out shareholders (I say likely because it is never possible to predict with any certainty whether a company will collapse or not).
The problem is that even the most experienced Wall Street analysts are unable to predict whether a company will go bankrupt in the next few weeks, months or even years. Buffett, it seems, is one of the investors who has such a talent.
So how do the average investors safeguard themselves from such a disaster? This is one question I’ve been asking myself ever since I started investing. Aside from developing a rigorous checklist to assess a company’s financial position, its position in the market and ability to maintain profit margins (which is never a precise art) the single metric that I have found is the most useful in assessing a company’s longevity is cash.
There’s a reason why they say cash is king in business. Without cash, a business won’t function. Even if a company is highly profitable if it’s not generating any cash its sustainability is questionable. Indeed, some of the largest corporate disasters of the past few decades have been easily distinguishable by their lack of cash generation. Following the case would have helped investors avoid disasters such as Enron and Worldcom. These scandals showed that earnings are easy to fake, but cash generation and cash on the balance sheet needs to be earned.
There are three cash metrics that can tell you an awful lot about the health of a company in a few minutes.
- Free cash flow.
- Cash conversion.
- Cash balance.
Free cash flow
First off, free cash flow is a tremendously useful measure for understanding the real profitability of a business; it's hard to manipulate, and the metric can quickly reveal whether a company’s operations are sustainable. If a firm is constantly reporting negative free cash flow, it’s possible the business won’t last much longer. As I said, cash is king in business and without free cash coming into the company, the firm will be unable to pay down debt, pay a sustainable dividend or build a healthy cash balance to protect against uncertainties. Without a positive free cash flow, a company will struggle to pursue these opportunities to enhance shareholder value.
Free cash flow is calculated as operating cash flow minus capital expenditures. The metric can be seen as the cash the company can generate after spending the money required to maintain or expand its asset base.
The cash flow from operations to net income ratio reveals the percentage of a company's total net income that is available as cash. This ratio is probably one of the most revealing metrics there is when it comes to understanding where the company’s profit is coming from.
Net profit can be (and frequently is) manipulated. Capitalizing charges such as research and development and interest costs, understating depreciation and booking profits before they’ve materialized are all ways of manipulating income.
However, while fancy accountancy work may be able to boost net income, it’s difficult to do the same with cash flows. The cash flow from operations to net income ratio is helpful in this regard. The ratio expresses cash flow from operations as a percentage of net income; the lower the percentage, the more likely it is that a company is using underhanded tactics to improve profitability.
The godfather of value investing, Benjamin Graham, made it clear that investors should only consider buying the securities of companies with a healthy cash balance and no debt. Today it’s hard to find companies that have no debt on their balance sheet; the allure of
Still, companies with cash-rich balance sheets do exist, and these are businesses that make the best investments. Debt can be highly toxic; it constrains a company’s expansion plans, puts pressure on management to make mistakes during economic downturns and leaves creditors in control if a company becomes insolvent. Staying away from companies with high levels of debt will help you avoid the permanent impairment of capital that comes with bankruptcy.
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