Cash flow measures the amount of cash that a company brings in and uses during the course of an accounting period (quarter or year) after all fixed expenses are eliminated.
This number is frequently called earnings before interest, taxes, depreciation and amortization (EBITDA).
The reason investors are interested in cash flow is that it gives them a clearer picture of what the company is truly doing.
DeductionsWhen you begin deducting interest, taxes, depreciation and amortization, you distort what positive or negative cash flows the companys operations generated.
The four items (interest, taxes, depreciation and amortization) have nothing to do with the companys actual operations and are accounting conventions for reducing income for tax purposes. Heres how each one distorts operating performance:
- Interest Companies can deduct interest expense from their income for tax purposes. This deduction will change from year-to-year as more or less debt is on the books.
- Taxes Taxes are subject to change as laws change and the companys business and accounting practices may change. This deduction also reduces net income.
- Depreciation The tax code allows companies to deduct a portion of the value of an asset each year over a predetermined schedule. This schedule should coincide with the useful life of the asset. For example, if the company bought a piece of equipment with a 10-year useful life, it could take one-tenth of its value as a deduction each year. This matches the expense of the equipment with the income it generates over its 10-year life.
- Amortization Amortization is the same as depreciation except for intangibles such as goodwill from the acquisition of a company. In this case, if the company paid more than the shareholder equity (a premium) the excess is goodwill and the company would amortize the cost.
Non-Cash DeductionsIt is important to note that both depreciation and amortization are non-cash items, that is they are expenses on paper only and do not involve any cash, yet they reduce the companys net income on the books.
Companies that make heavy investments in capital equipment or buildings and real estate may have so much depreciation that they show very little if any in the way of earnings, yet may be generating strong cash flows.
How to UseCash flow is an important measurement and is best understood when you compare a company to its peers and to the market.
Fortunately, a number of Web sites make the calculations for you. One of the best is Reuters.com.
Enter the symbol of the company and go to the quote page. On the left side navigation, click on ratios. This will take you to a page of valuation ratios where you will find the cash flow ratio among others.
The company is compared to the industry as a whole, its particular sector and the S&P 500. You can readily see if where the market is pricing the stock.