Evaluating the Distribution of Cash Flows
- Are the accounting standards that management uses conservative or liberal?
- Does the business generate revenues that are recurring or from one- off transactions?
- To what degree is the business cyclical, countercyclical, or recession-resistant?
- To what degree does operating leverage impact the earnings of the business?
- How does working capital impact the cash flows of the business?
- Does the business have high or low capital- expenditure requirements?
The fifth section of the investment checklist, "Earnings (Cash Flows)," involves assessing the company's profitability and the consistency and sustainability of its earnings and cash flows. A company's ability to generate stable and growing earnings and cash flows is often seen as a sign of financial health and business success.
- Earnings Consistency: Investors should look at a company's historical earnings to see if they have been stable or growing over time. Significant fluctuations may signal volatility in the company's business model or market.
- Earnings Growth: A company with a track record of steady earnings growth is often a positive sign. This indicates that the company is expanding and its business model is working.
- Profit Margins: It's important to consider profit margins, including gross margin, operating margin, and net profit margin. High and improving margins often indicate a company's ability to control costs effectively and its pricing power.
- Cash Flow from Operations: This represents the cash that a company generates from its core business operations, excluding investing and financing activities. Positive and growing cash flow from operations often indicates that a company's business is robust and well-managed.
- Free Cash Flow: Free cash flow (FCF) is the cash remaining after a company has paid its expenses and invested in its future growth. It's an important measure of a company's financial flexibility and its ability to reward shareholders through dividends or share buybacks.
- Cash Conversion Cycle: This metric measures how efficiently a company converts its investments in inventory and other resources into cash. A shorter cash conversion cycle is usually better.
Understanding a company's earnings and cash flows helps investors evaluate the company's performance, profitability, and financial health. It also aids in forecasting future earnings and cash flows, which are critical inputs in valuation models.