How cash flow can be used to unearth value investments

With reporting season just around the corner, it's important to understand how you can cut through the spin to find out what a stock's result and balance sheet really looks like. The best stocks to invest in are typically those that produce an ongoing funding surplus, and you can use cash flow to find them.

There's no better insight into what's left for you as a shareholder in a business once it's paid all its bills, than an analysis of cash flow. When it comes to assessing the investment quality of a company's cash flow, you should be attracted to those with sufficient money in the bank to fund their operations and produce an ongoing funding surplus.

Given that every business operates to generate cash, you should typically be wary of stocks that repeatedly show a funding gap, which occurs when there's insufficient cash to continue operating and the company is forced to take on debt or raise capital, which only serves to dilute shareholder value.

Surplus or gap 

You can identify any stock's funding surplus or gap by subtracting the capital expenditure, investments and dividends paid from the company's cash flow generated from operations – which is the sum total of cash flows from the company's day-to-day trading activities.

The greater a company's funding surplus the more likely it is to avoid excessive borrowing, expand its business, pay dividends and withstand any economic downturns. Unsurprisingly, this explains why so few stocks listed on the ASX actually have investment grade balance sheets.

While it's not always a simple exercise, thanks to Australia's complex accounting standards, it's important to understand whether a company is self-funded – generating more money than it spends – or relies on external funding, after factoring in its operations, investments and financing to finance its activities.

What you should be looking for is companies that have consistently generated rising profits and improving cash flow generated from operations, relative to reported net profit after taxes.

Take for instance appliance maker Breville Group (ASX:BRG), which since 2006 has invested $96.9 million, paid dividends of $181.8 million and paid out other financing cash flows and foreign exchange effects of $3.4 million, resulting in a funding surplus $115 million, which gives it an attractive cash flow ratio of 1.24.

What Breville's funding surplus indicates is that the company doesn't currently rely on external sources of capital to fund its business activities. Based on the strength of its low debt (net-debt to equity -14.17%), healthy bank account, future return on equity (ROE) projections above 20%, and healthy cash flow surplus, Breville is regarded as having an investment grade balance sheet.

Another stock that passes the cash flow test is the Reject Shop (ASX: TRS), which in addition to having a cash balance that exceeds debt, also has strong cash flow relative to recorded profits, a net-debt to equity ratio of -3.95%, a cash flow ratio of 1.55, (above 0.80 preferred) and is forecast to deliver excellent earnings per share (EPS) growth.

Three other stocks that have repeatedly passed the cash flow test include: Monadelphous (ASX: MND), Technology One (ASX: TNE), and ARB Corporation (ASX: ARB).     

Be wary of big-caps with bad cash flow 

Despite their market positioning and house-hold brand awareness, many so-called 'blue-chip' stocks can and do carry unhealthy cash positions, and it's easy for uninformed investors to assume that due to their size, they're always safe-haven investments.

There's no shortage of both high profile and smaller stocks on the ASX, with a history of large debt, that have continually struggled to pass the cash flow test, and these include: Namoi Cotton (ASX: NAM), Funtastic Ltd (ASX: FUN), Paladin Energy (ASX: PDN), Lynas Corporation (ASX: LYC) , and Lend Lease (ASX: LLC) which since 2006 has reported net profit after taxes of $3.8 billion, and generated $2.4 billion from cash flow operations – which gives is an unacceptable cash flow ratio of 0.65.

Don't overlook cash flow

A company's cash flow is a crucial ingredient in producing sufficient money in the bank to fund operations, pay dividends and produce a funding surplus.

That's why it's important to look for those companies that have something left over for you as a shareholder, after they've paid their bills. These stocks are typically the ones that will produce lasting and growing value in your portfolio.

When running a ruler over stocks this reporting season, find out answers to the following key questions:

  • Is the company making a profit, and are profits rising?
  • Is cash flow relative to reported profits strong?
  • Does the company pay a dividend, and if so does the dividend exceed profits?

 

Stocks with good and poor cash flow typically exhibit the following key characteristics

Poor cash flow    

Good cash flow

Declining or negative reported net profit after taxes.

Cash dividends that frequently exceed reported profits.

Cash flow generated from operations that's usually lower than reported net profit after taxes.

An ongoing funding gap.

 

Rising reported net profit after taxes.

Cash dividends that do not exceed reported profits.

Cash flow generated from operations that is higher than reported profits.

An ongoing funding surplus.