Question: In an economics course I took, we were told that a company's cash flow is very important...but not much else was said.

Art Kincaid

Answer:

Dear Art,

The cash position is one of (if not "the") most important aspects of judging a company and deciding if you wish to own its stock. No matter how great its products or services, how attractive its real estate, how sophisticated its advertising campaign and prominent its public image -- if it has insufficient cash reserves for running the business, doing research and development and taking advantage of new opportunities, it could lose out to its competitors.

A strong cash position gives a company the money with which to raise outside capital, to advertise, to make timely acquisitions, to pay interest on its bonds, to grant dividends to shareholders and equally important, to weather difficult times, even recessions.

A FASB (Federal Accounting Standards Board) ruling requires public companies to issue annual cash flow statements. Therefore, I recommend that you get a copy of the annual and quarterly reports for any companies in which you own stock and for those you are considering. With those in hand, here are three ways to do your own cash flow analysis.

(1) The easiest ratio involves dividing the total amount of cash a company has on hand by the amount of long-term debt. A position under 20% is generally regarded as risky.

(2) A popular ratio among professional security analysts is the "acid-test ratio" also called the quick ratio or liquidity ratio. It measures a company's liquidity and ability to meet its short-term debts without dipping into inventory. Take cash on hand plus cash equivalents (marketable securities, accounts receivable and notes receivable) and divide them by current total liabilities.

If the ratio is 1 to 1 or higher, the company is considered comfortably liquid. Of course, the higher the ratio, the greater the liquidity.

(3) The "cash asset ratio" is also very helpful in analyzing a company. It consists of the total dollar value of cash on hand plus marketable securities. This figure is then divided by current liabilities. It measures the extent to which a company can quickly liquidate assets and cover short-term debts. Therefore, it is also referred to as the liquidity ratio.

A Cash Cow

In the process of reading about cash flow, you may come upon the phrase "cash cow." This is a company that generates a healthy stream of cash. A cash cow is typically (but certainly not always) one that has famous brand names that people like and return time after time to purchase. Cash cows also tend to pay dividends to shareholders and also to regularly increase those dividends.

More Info...

If you find this type of stock analysis of interest, I recommend these sources for further unbiased advice.

• American Association of Individual Investors. This consumer group has two valuable publications at: www.aaii.com:
  
  "Mapping Earnings: Finding the Bottom Line in Profits" and "Four Basic Steps in Gauging a Firm's True Financial Position."
  
  
• New York Stock Exchange. Go to: www.nyse.com and in the search box type: "Reading Annual Reports."
  
  
• How The Stock Market Works by John Dalton; published by the New York Institute of Finance. I often recommend this book and in your case, suggest reading Chapter 13, "Analyzing Stocks: The Corporation's Report Card."

Good luck!