Valuing a share: Show me the cash flow

When it comes to weighing up a company, many people focus on profits, earnings per share (EPS) and dividends. That's primarily because they are relatively easy to understand. But smarter investors pay less attention to these items and more to the lifeblood of a company: cash flow.

The reason behind this is very simple. Good companies generate lots of surplus cash (free cash flow) over the long term. This can be used to pay shareholders large dividends or be invested to produce even more cash flow in the future.

So if you want to know how a company is really performing, it's crucial to dig into where it gets its cash from and what it does with it. You do this by building what is known as a sources and uses statement'.

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You should base this on at least five years' data preferably ten. By doing so, you can see patterns emerging that could allow you to uncover a wonderful investment or find warnings that something is starting to go wrong.

Where to look

An income statement (or profit-and-loss account) which is where you find profits, EPS and dividends shows you the income that is flowing into a company from selling its goods and services. But it doesn't say anything about cash flow.

For this, you need to turn to the cash-flow statement, which will be in the annual report andaccounts. This tells you most of what you need to know about the cash coming in and the cash going out.

The first step, once you have the cash-flow statement, is to work outthe company's free cash flow. The calculation for this is: trading cash flow less net interest paid, less capital expenditure (capex), less tax. That'suseful in itself, but you can learn a lot more by digging deeper into what caused changes in the company's cash balance throughout the year.

Usually the biggest source of cash comes from selling goods and services trading or operating cash flow. However, there are other significant sources of cash such as new bank loans, proceeds from new share issues, interest income and asset sales.

Cash is used on things such as paying interest on debt, the taxman, new plant and machinery (capex), buying new businesses, repaying loans and those all-important dividends to shareholders.

By studying all these moving parts, you can pose plenty of probing questions.For example, is a company borrowing lots of new money? Is it selling assets to pay dividends?

It's a good idea to calculate cumulative totals to helpyou figure out what's been going on and what might happen in the future. In the box below, you can see an example of a sources-and-uses statement and the type of warning signs that it can help you spot.

A worked example

Sainsbury's profits over the last five years suggested all was well. Cumulative EPS has been 140p, while total dividends were 79.4p per share. Last year's payout of 17.3p was covered 1.9 times by earnings. So why has it just announced that its full-year dividend will be cut?

By now, you'll have read about how bad things are for Britain's supermarkets. But in fact, Sainsbury's cash flow has been warning us for a while that its dividend may have been too generous. Yes, on the face of it, things seem OK.

The sources and uses of cash (right) shows that over £10bn has come in and just over £9bn has gone out over the last five years. But look more closely and red flags start appearing.

Over this period, Sainsbury's generated over £6bn from its core business, but has ploughed most of it back into building new stores and sprucing up old ones. After paying tax and interest, it's spent over £500m more than it took in (the adjusted free cash flow' line near the bottom of the table). So how has it paid for £1.4bn in dividends?

We can see it sold £1.3bn of assets (asset sales'), took on nearly £400m of net borrowings (new borrowings' minus repayments') and gained £1bn in cash from taking full ownership of Sainsbury's Bank (net cash acquired').

You can't raise cash like this forever. When the chance to do so is gone, the company is not generating enough cash from trading. This is why it is slashing what it spends on its stores, which should mean it has enough cash to pay the lower dividend.