Cash Flow Analysis: Why Cash is King in Investing

Why Cash Flow Matters More Than Profit

Warren Buffett famously said: "Cash is king." While net income (profit) gets all the headlines, cash flow is what actually pays the bills, funds growth, and returns money to shareholders through dividends and buybacks.

Here's the fundamental truth about business: You can't pay employees, suppliers, or dividends with accounting profits—you need actual cash.

Profit vs Cash Flow: What's the Difference?

Net Income (Profit): Calculated using accrual accounting, which records revenue when earned (not when cash is received) and expenses when incurred (not when cash is paid).

Cash Flow: Tracks the actual movement of cash in and out of the business.

Why Investors Prefer Cash Flow Over Earnings

• Harder to Manipulate: Accounting rules allow earnings manipulation through depreciation schedules, revenue recognition timing, and reserves. Cash flow is objective—cash is either there or it isn't.
• Survival Indicator: Companies with positive cash flow can weather recessions; those burning cash eventually need expensive financing or bankruptcy.
• Valuation Driver: Discounted Cash Flow (DCF) models value companies based on future cash flows, not earnings.
• Dividend Sustainability: Dividends are paid from cash, not accounting profits. If operating cash flow < dividends paid, the dividend is unsustainable.

The Cash Flow Statement: Three Critical Sections

The cash flow statement reconciles net income to actual cash changes. It's divided into three sections:

1. Operating Cash Flow (OCF) - The Lifeblood

What it shows: Cash generated from the company's core business operations.

Formula: Net Income + Non-Cash Expenses (Depreciation, Amortization) + Changes in Working Capital

Key Components:

• Net Income: Starting point (from income statement)
• Add Back Non-Cash Charges:
  • Depreciation & Amortization (D&A): Accounting expenses that don't involve cash leaving the business
  • Stock-based compensation: Employee stock grants (non-cash expense)
• Adjust for Working Capital Changes:
  • Increase in Accounts Receivable = Cash outflow (customers owe you money but haven't paid)
  • Increase in Inventory = Cash outflow (cash tied up in unsold goods)
  • Increase in Accounts Payable = Cash inflow (you received goods but haven't paid suppliers yet)

2. Investing Cash Flow - Growth Spending

What it shows: Cash spent on long-term investments (usually negative).

Typical Items:

• Capital Expenditures (CapEx): Cash spent on PP&E (property, plant, equipment)
  • Example: Tesla building a new factory ($5 billion)
  • CapEx is necessary to maintain/grow business operations
• Acquisitions: Buying other companies
  • Example: Microsoft buying Activision Blizzard ($69 billion)
• Asset Sales: Selling equipment, real estate, or business units (positive cash flow)
• Investments in Securities: Buying/selling stocks, bonds, or other financial instruments

What "Normal" Looks Like: Investing cash flow is usually negative (companies invest cash to grow). Red flag if consistently positive—may indicate the company is selling assets to raise cash.

3. Financing Cash Flow - How the Company Funds Itself

What it shows: Cash flows between the company and its investors/lenders.

Typical Items:

• Debt Issuance/Repayment:
  • Borrowing money = Positive cash flow
  • Paying off debt = Negative cash flow
• Dividends Paid: Cash returned to shareholders (negative)
• Stock Buybacks: Repurchasing shares (negative)
• Issuing New Stock: Selling shares to raise cash (positive)

Free Cash Flow (FCF): The Ultimate Metric

Free Cash Flow (FCF) is the cash available after the company pays for operations and capital expenditures. It's the cash that can be returned to shareholders or used for acquisitions.

Why FCF Matters

• True Owner Earnings: FCF represents cash the owners could theoretically extract from the business.
• Valuation Metric: FCF Yield = FCF / Market Cap (similar to dividend yield, but includes all cash available, not just dividends)
• Dividend Sustainability: If dividends > FCF, the payout is unsustainable.
• Growth Indicator: Growing FCF over time signals a healthy, expanding business.

Key Cash Flow Metrics

1. FCF Yield

Formula: (Free Cash Flow / Market Capitalization) × 100

Measures how much cash flow you get per dollar invested.

• FCF Yield > 5%: Attractive (similar to a 5% dividend)
• FCF Yield 2-5%: Reasonable
• FCF Yield < 2%: Expensive (growth stocks often trade here)

2. Cash Conversion Ratio

Formula: Operating Cash Flow / Net Income

Measures how efficiently profits convert into cash.

• Ratio > 1: Excellent (generating more cash than reported profit)
• Ratio 0.8-1.0: Good
• Ratio < 0.8: Concerning (profits not converting to cash)

3. Operating Cash Flow Margin

Formula: (Operating Cash Flow / Revenue) × 100

Measures how much cash the company generates per dollar of sales.

• Margin > 20%: Excellent (software, tech companies)
• Margin 10-20%: Good
• Margin < 10%: Low-margin business (retail, groceries)

4. CapEx as % of Revenue

Formula: (Capital Expenditures / Revenue) × 100

Indicates how capital-intensive the business is.

• < 5%: Asset-light (software, consulting)
• 5-15%: Moderate (most industries)
• > 20%: Capital-intensive (telecom, manufacturing, utilities)

Real-World Example: Tesla vs Ford Cash Flow

Let's compare two automakers with very different cash flow profiles.

Analysis:

• Tesla's Strength: Higher OCF margin (13.7% vs 6.5%) shows more efficient operations despite lower revenue.
• Ford's Strength: Cash conversion ratio of 2.67 means Ford generates $2.67 in cash for every $1 of profit (working capital improvements).
• CapEx: Both companies spend similar amounts on CapEx (~$8-9B), but Tesla is building new factories while Ford maintains aging infrastructure.
• Free Cash Flow: Tesla edges out Ford despite half the revenue—sign of superior unit economics.

Red Flags in Cash Flow Analysis

1. Negative Operating Cash Flow

If a company can't generate cash from operations, it's burning through reserves and will eventually need financing.

When It's Acceptable: Early-stage growth companies (startups, biotech) burning cash to capture market share.

When It's Alarming: Mature companies with negative OCF (sign of deteriorating business).

2. FCF < Net Income for Multiple Years

If free cash flow is consistently below net income, the company is spending heavily on CapEx or has working capital issues.

Red Flag Formula: FCF / Net Income < 0.7 for 3+ consecutive years

3. Rising CapEx Without Revenue Growth

If capital expenditures are increasing but revenue is flat, the company is getting diminishing returns on investments.

Example: Legacy telecom companies spending billions on 5G infrastructure with minimal revenue growth.

4. Dividends > Free Cash Flow

If dividends paid exceed FCF, the company is borrowing or selling assets to fund payouts—unsustainable.

Sustainable Dividend Formula: Dividends / FCF < 0.8 (80% payout ratio leaves cushion)

5. Deteriorating Working Capital

Rapidly increasing accounts receivable or inventory relative to revenue signals:

• Customers not paying on time (credit risk)
• Inventory piling up (slowing sales)
• Aggressive revenue recognition (booking sales before cash collected)

6. Stock-Based Compensation > 5% of Revenue

Excessive stock grants dilute shareholders and inflate operating cash flow (SBC is added back as "non-cash expense").

Tech Companies to Watch: Some startups use 10-20% SBC to conserve cash—massive shareholder dilution.

How to Analyze a Cash Flow Statement (Step-by-Step)

Step 1: Check Operating Cash Flow Trend

Pull 5 years of cash flow statements. Is OCF growing, stable, or declining?

• Growing OCF: Healthy business expanding profitably
• Declining OCF: Warning sign—investigate why

Step 2: Calculate Free Cash Flow

FCF = OCF - CapEx. Compare FCF to net income.

• FCF > Net Income: Quality earnings (low CapEx requirements)
• FCF < Net Income: High CapEx needs (capital-intensive business)

Step 3: Analyze Working Capital Changes

Look at changes in AR, inventory, and AP. Are they growing faster than revenue?

Step 4: Review CapEx Trends

Is CapEx as % of revenue stable, increasing, or decreasing? Cross-check with revenue growth.

Step 5: Examine Financing Activities

Is the company raising debt, issuing stock, or returning cash to shareholders?

• Mature Companies: Should have negative financing CF (paying dividends, buybacks)
• Growth Companies: Often have positive financing CF (raising capital)

Where to Find Cash Flow Statements

• Company Investor Relations: Search "[Company] investor relations" → Financials → 10-K or 10-Q
• SEC EDGAR: sec.gov/edgar
• Financial Websites: Yahoo Finance, Google Finance, Seeking Alpha (Cash Flow tab)

Conclusion: Cash is King

While net income gets the headlines, cash flow tells the true story of a business. Companies with strong, growing free cash flow can:

• Survive recessions without emergency financing
• Fund growth organically (no dilution)
• Return cash to shareholders through dividends and buybacks
• Make strategic acquisitions

As Warren Buffett said: "In business, I look for economic castles protected by unbreachable moats"—and those castles are built on cash flow, not accounting profits.