Looking for a great investment? Then follow the cash

What’s the most important measure of how a company is doing?

If you only ever read the business sections of the papers, you’d almost certainly think ‘profits’. You see headlines about them ‘plunging’ or ‘soaring’ every other day.

Now, there’s nothing wrong with looking at profits. A company that can’t grow its profits over the long run is very unlikely to turn out to be a good investment.

But it’s dangerous to fixate on profits because they don’t always paint a true picture of what’s going on. In fact, it’s entirely possible for a healthy-looking company to blow up in your face if you focus on profits alone.

That’s because profits aren’t the same as cash. And as an investor, cash is ultimately what really matters. ‘Cash is king’, as the old cliché goes.

Here I’ll explain why – and how to check on a company’s cash flow situation.

Profits and cash are nothing like the same thing

How can profits and cash differ so widely?

You have to recognise that a company’s profits are based on what’s known as the ‘accruals’ or ‘matching’ concept.

Put simply, this means that costs and sales are recorded in the accounts when they happen, NOT when the cash involved in these transactions is paid or received.

For example, a carpet shop might sell a carpet for £1,000. The customer gets 60 days to pay for it (credit, in other words). But the £1,000 gets booked as a sale when the carpet is dispatched, not when the cash is received.

Say the carpet vendor paid the manufacturer £800 for the carpet. (We’ll ignore all other costs, such as heating and lighting the shop, etc, for now). Take £800 in costs away from the £1,000 sale price, and you’ve got £200 in profit.

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But there’s still no money sitting in the bank. And let’s say the manufacturer wants paying in 30 days. So the carpet shop has to pay out £800 in 30 days’ time, but it’s not going to get the £1,000 for another 60 days.

Now, you might be able to fob off a supplier in extreme circumstances. But say that was an £800 interest payment on a loan to the bank, or a cheque for the quarterly rent you had to come up with. It’s perfectly possible the company would be shut down.

That’s how a company can be sitting on big paper profits, but still go bust.

There are other oddities about profits that have nothing to do with actual cash coming in or out of the business. Profits are also reported after expenses such as depreciation. This is a yearly charge for using an asset such as a machine over its useful life.

Say a company has some machinery that cost £500m. The equipment is supposed to last for ten years. So the depreciation charge reduces profits by £50m a year (500/10). So if the company’s profits before depreciation are £150m, the depreciation charge reduces profits to £100m.

But this has nothing to do with the actual cash being spent on the equipment. The company might have paid out £500m in year one, and then no more for the next nine years. Or it might have taken out a loan. Whatever the method of payment, the depreciation charge will be quite different.

Also, depreciation figures can be fiddled if company directors want to boost profits artificially. Say the directors of the company above decide that the equipment will last for 20 years, not ten. Now the annual depreciation charge falls to £25m (500/20) and profits go up to £125m (150-25).

Cash flow is a much cleaner measure of success

In short, profits can include a lot of expenses where cash doesn’t go out of the business. And sometimes they include sales where the cash hasn’t come into the business. 

How can you get past this?

The good news is that if you look at a company’s cash flow rather than its profits, then these accounting tricks and traditions won’t get in the way. Because they make no difference to the actual cash flowing in and out of the company.

So which measure of cash flow is most useful? Well, what you really want to know is the difference between the amount of cash coming in, and the amount going out. If more cash is going out than coming in, or the amount coming in is steadily falling year by year, you’d better work out why. Because that state of affairs can’t continue for long without a company going bust. And it can’t pay you a dividend if it doesn’t have any cash to do so.

In the investment world, this measure is known as free cash flow. It’s the amount of surplus (or ‘free’) cash flow a company has at the end of the year after it has paid for everything it needs in order to stay in business.

How to calculate free cash flow

Free cash flow is not too hard to calculate. You can find all the information you need in the company’s annual report, on the cash flow statement.

You start off by taking the company’s operating cash flow. This is the cash it gets from trading. This takes into account things like when it receives the cash from its sales and when it pays its suppliers. It also factors in the fact that depreciation – which reduces trading profits – does not have any impact on trading cash flow.

Secondly, you have to take into account cash coming into the business, such as dividends from company investments, and interest on cash in the bank.

Then you should deduct any interest paid on company borrowings, and the money paid to the taxman.

Finally, you have to take account of any fixed assets the company has bought, such as new buildings, or intangible assets such as computer software. You should also account for any cash raised by selling such assets that the company no longer needs.

After you’ve done all this, you will have a number for the company’s free cash flow.

To show you how this all works, in the table below I’ve calculated this number for British American Tobacco (BAT).

BAT Cash flow  2011 (£m)
Operating cash flow 5,537
Dividends received 478
Interest received 79
Tax paid -1,447
Interest paid -580
Assets bought -617
Assets sold 45
Free cash flow 3,495
Dividends paid out 2,633
Free cash dividend cover 1.33
Net profits 3,095
FCF as a percentage of net profits 113%

As you can see, BAT has lots of free cash flow, In fact, its free cash flow is higher than its net (after-tax) profits. This can be a hallmark of a very good company to own, provided that it isn’t scrimping on its costs too much, or under-investing in its assets (a company that doesn’t keep its assets up to date and in good condition is storing up long-term trouble).

BAT’s surplus cash also allows it to pay big dividends to its shareholders. As you can see from the table above, its free cash flow more than covers its dividend payments.

Companies that keep growing cash flows can be very good investments

So why does free cash flow matter so much? Ultimately, growing free cash flow displays a well-run company that is constantly growing its income, and that’s exactly what you want as an investor.

One study by Oxford Systems Trader in the US found that companies that grew their free cash flows by more than 10% a year over five years outperformed the stock market by 286%.

BAT is a perfect example. Between 2006 and 2011, its net profits increased by 63%, but its free cash flow more than doubled. If you had bought the shares at the end of 2006, reinvested all your dividends and then sold them at the end of 2011, your total return would have been 166%. Doing the same thing with a FTSE 100 tracker fund would have given you a return of minus 7%.

So provided you don’t pay too much for the shares in the first place, buying companies with a growing free cash flow is a very good way to make money.

• This article is taken from our beginner’s guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here