Cash (Flow) is King

When it comes to evaluating investment opportunities, cash reigns.  Maybe not literally in the sense of a monarch, but something pretty close.  While net income or “earnings” get all the publicity, even a dedicated “season” each quarter, another measure of shareholder income dominates long-term returns.  That measure is free cash flow.

I will start by saying that net income is nothing to be ignored.  A thoughtful investor will consider each line in the income statement from revenue to profit.  That said, as the management team for each company evaluates capital allocation decisions, cash is the starting point, not “adjusted earnings per share”.  A successful business will produce cash flow by way of normal operations.  These cash flows are reported on the cash flow statement.  Cash flow from operations are calculated by adjusting net income for non-cash transactions.  These resulting cash flows can then be allocated as management sees fit.  First, most business require some level of capital expenditure just to maintain and, hopefully, expand operations at a profitable clip.  Once capital expenditures are accounted for, the company is left with what can be thought of as free cash flow.

This free cash flow is the liquidity that could be distributed to shareholders via dividends or share repurchases.  A company that does not produce free cash flow can return cash to shareholders, it just must finance the payments somehow.  A company with negative cash flow could borrow money or sell new shares to raise cash to cover a dividend.  We see this fairly regularly in years where companies plan to make large, irregular capital investments.  That said, obvious questions would arise if such an approach became a strategy over a longer-term.  It is also important to note that more free cash flow is not always better.  If a company refuses to make necessary capital expenditures, short-term free cash flow might be boosted, but it could come at a detriment to long-term performance.  As a shareholder, we would hope that management would prioritize high return-on-investment capital expenditure.  Even over dividends and share repurchases.  If a company has an opportunity to make a capital expenditure that is likely to produce a 20% annual return on investment, a rational investor would much prefer that the company make such an investment rather than paying a dividend or repurchasing shares.  Were the company to pay out cash instead of making such an investment, the shareholder receiving the cash is unlikely to have equivalent return opportunities over a longer-term.

There will come a point at which projects with high returns fail to materialize.  At that point, we are left with the free cash flow to be allocated at management discretion.  While dividends and share buybacks are two uses of this cash, they are not the only options.  Indebted companies might use some of this liquidity to reduce overall debt loads.  Other firms might retain the cash to fund future expenditure or to shore up their balance sheet.  Still other firms might use cash to make new investments by way of acquisition or even capital market investments.  An appreciation for the use of the cash is vital as it helps illuminate how much cash shareholders can expect to receive from their company or to project future balance sheet positioning.

The cash flow statement cannot be evaluated in a vacuum though.  The income statement can help an investor gain a grip on things like growth and operating efficiencies and the balance sheet is necessary to understand capital structure, returns on capital, and cash on hand.  Ultimately though, the differentiator is cash.  If a company can produce it at a growing rate, with minimal capital employed, shareholders will likely be rewarded.

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