Three questions every investor must ask

Every sensible investor should dig out a firm's cash-flow statement before putting money into a business. This will enable you to answer three crucial questions. Tim Bennett explains.

Three numbers from insolvency specialist Begbies Traynor capture the scale of our current economic problems. In an average year there are 12,000 insolvencies, the group says. In 1992, at the height of the last recession, 30,000 firms went under. Yet this year, Begbies reckons more than 36,000 companies face administration. As Begbies says, "it is going to be a very grim 2009".

And it's not just about the credit drought. Furniture retailer Land of Leather collapsed this month. The firm was largely debt-free its trouble was that it simply wasn't selling enough sofas. This is a valuable reminder for investors that there's more to a safe company than low borrowing or gearing ratios. Low debt doesn't help if there's no money coming in the door to pay wages and rent. So you have to dig out a firm's cash-flow statement too. This 12-month summary of a company's cash inflows and outflows will enable you to answer three crucial questions.

Where does the cash come from?

Just as you can supplement a salary by extending the mortgage or selling off the family silver, so a firm can boost short-term cash flow by borrowing or selling off assets. But there are only so many assets you can sell. Without a regular income an individual or a firm will quickly run out of cash.

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So locate the most important number near the top of the cash-flow statement: 'cash flow from operating activities'. This shows how much cash the firm generates from its core business activity. A negative number is a huge red flag. Then check back a few years. Highly volatile operating cash flows can suggest trouble Enron was a classic case in point before it failed.

A firm can also enhance operating cash flows by delaying payments to suppliers just before the financial year-end. So take a look at the note that supports the cash-flow figure, often a few pages back, and in particular the line covering 'change in creditors'. If the number has jumped without a corresponding rise in activity 'cost of sales' in the profit and loss account, be suspicious. It's also worth comparing the firm's 'operating profit' to its operating cash flow. Big variations, or an operating profit not at least matched by a similar amount of operating cash flow, are both warning signs.

Where does all this cash go?

Next, look at where all the operating cash flow goes. First, check the 'free cash flow'. Analysts often quote this, or you can do your own estimate. Take 'cash flow from operating activities' and deduct non-discretionary spending, such as interest paid to lenders and banks, tax paid and however much the firm needs to spend on new long-term assets to stay in business. The first two can be found separately flagged on the main cash-flow statement slightly further down. The last one can't, but may be approximated by using the annual deprecation charge an accounting estimate of one year's wear and tear.

Free cash flow should be positive and ideally consistent with past years, allowing for changes in activity so if sales have decreased by, say, 10%, free cash flow will probably have fallen too but not by 50%, for example. Firms then have a choice about how they apply free cash flow. Tesco has expanded rapidly in the past by using huge free cash flows to buy new freehold sites. But if a firm is enjoying lots of free cash flow and not expanding or paying it back to investors as a dividend, be concerned. What return is it generating for you to justify your continued support? Also crucial to most investors is the relationship between free cash flow and the equity dividend. Be worried if free cash flow doesn't cover the dividend at least twice, as future payouts might be at risk.

How is the firm financed?

The final area to look at is the 'cash flows from financing activities' section. Just as you shouldn't extend your mortgage to pay for day-to-day living, so for firms the rule of thumb is that short-term finance pays for short-term activities (management of customers, trading stock and suppliers, for example) and long-term finance pays for investment. A typical bankruptcy candidate will raise long-term finance as new debt or equity and then use it simply to keep trading. So compare the total raised as debt or equity in the 'cash flows from financing activities' section and the amount being spent on new assets in the 'cash flows from investing activities' above it. A big mismatch with no explanation from directors is another warning sign.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.