Fundamental Analysis and Position Trading: Evolution of a Trader

CHAPTER 5

Cash Flow

Cash flow is what keeps a business running. If Joe's Manufacturing runs out of cash, then they cannot pay their employees, and cannot buy materials to make the things they sell. If the shortfall lasts long enough, the operation grinds to a halt like a car running without oil. Another term for that is bankruptcy.

Consider earnings per share. If earnings go negative, what happens? Does the electric utility threaten to turn off the lights? No. The company can exist with negative earnings for years, but if the cash flow dries up, then they are in serious trouble.

Biotechnology companies are a good example. They are often unprofitable for years until their blockbuster drug gets approved and the cash starts tumbling in.

What about the opposite of a cash starved outfit? Let us call it the cash cow. Investors dream of owning cash cows, but what should the company do with all that extra cash?

When a company uses its free cash flow (operating cash flow minus capital spending) wisely, earnings can explode in future years. Dividends can increase, debt can drop, they can buy back shares, or reinvest in the company to continue the trend. Free cash flow is what remains after paying all of the bills.

• Free cash flow is operating cash flow minus capital expenditures.

If we were to look at a cash flow statement, it would appear in three parts:

1. Operating cash flow (often called just cash flow) represents the core of cash-generation activities. It is sales less the cost to ...