Negative cash flows usually set off alarm bells for investors, and for good reason. At the end of the day cash is the lifeblood of a business.
Still, a closer look at things may just reveal a company that is sensibly investing in its future growth. If you can go beyond the surface-level numbers, and build some confidence in the capital allocation decisions of management, it might even help you get ahead of the market.
Business cash flows encompass three main components: operating cash flows, investing cash flows, and financing cash flows. And you need to understand all three to get a sense of what is going on.
Operating cash flows are, of course, critical. A business that can self-fund operations and reliably add to its treasury is on a firmer footing than one still reliant on investors and banks. But things like increases in working capital and headcount, both of which can be necessary precursors for growth, can muddy the waters here.
This is where comparisons with EBITDA and profit can sometimes be helpful. The point is that the true return of some operating cost increases may not be apparent for a little while, so in some circumstances it’s appropriate to give management a little rope.
But if there’s no subsequent boost to sales, or some clear operational benefit, you could start to question how well the business is run.
Now, a lean, well-run business is fantastic. But if you want growth and the prospect for outsized returns, it’s the investing cash flows that really matter.
These flows relate to the cash used for (or generated from) investments in long-term assets. Anything that could generate future cash flows, such as property, plant, and equipment, as well as acquisitions. Tracking this over time, and contrasting it with things like Return on Incremental Equity, will give you a really good sense of how savvy management are as capital allocators.
Frankly, when you find a team with good form on this front, most other considerations become secondary. Especially when the key decision makers enjoy competitively advantaged reinvestment potential.
Lastly, financing cash flows — things like issuing debt or equity, paying dividends, or repurchasing shares — are also worth consideration.
When capital is cheap and sensible investment opportunities abound, it’s a good thing to see lots of new money coming in here. Even if that does result in some near-term impact to debt levels or even share dilution (within reason). Just remember that the reverse is equally true; indeed, profligate spending and mal-investment during the good times always ends up laying the foundations for future pain.
Of course, the ultimate goal is to have an entity that, over its lifetime, provides shareholders with far more cash than was put in. Just know that optimising for that often means limiting dividends/buy-backs in the near term.
All of which is to say that it takes money to make money, and Rome wasn’t built in a day.
As always, you want to build a holistic view of things. No matter how expert your cash flow analysis is, you won’t get too far without some understanding of all the myriad qualitative factors at play. But when couched in the proper context, a good understanding of the cash flows — and the factors that drive them — is a genuine source of edge.
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