How to Know If a Business is Really Making Money or Not
I only invest in companies that are really making money.
Why do I say that?
Most companies in the stock market don't make any money at all.
70% to 80% of the stock-market-listed-companies do not produce free cash flow.
To figure out whether the company is really making money or not, I download their annual reports, and look at the cashflow statement for the past 10 years.
If I am looking at 10 different cashflow statements, that gives me a very clear picture, as to what the company is up to.
The first thing I look at, in a cash flow statement, is the operating cash flow.
This is the money that the business is actually generating from doing business, like selling a product or a service.
Revenue minus all of the expenses including taxes, is the operating cashflow.
I am talking about cash revenue and cash expenses. Not accounting revenue / expenses.
If operating cashflow is negative, the company is not making any money.
So, my first criteria is that the operating cashflow must be positive over a period of 10 years.
In each of the 10 years, that number should be positive.
In banking and in financial companies, the calculation is a bit different.
There, you have to look at financing and investing cash flow.
But in general, cashflow from operations should be positive, every single year, for the past 10 years.
If you find a company where this number is negative, even in a single year in the past 10 years, simply reject the company.
Next, I look at, where is the company actually investing this operating cashflow.
Where is the money actually going?
1) Organic Growth.
The company will take the money and add more production capacity.
They will invest in plant and machinery.
2) Inorganic Growth
The company will use that money to acquire other companies in the same sector, or maybe some related sectors.
3) Financial Investments
If there is something left over, after making capital expenditure and acquisitions, that money will be parked in financial investments, like stocks, bonds, mutual funds, liquid funds, etc...
This shows you the flow of cash.
The money comes from operations, then it goes to organic growth, which is capital expenditures, then it goes to acquisitions, and then to financial investments.
If still there is some money left over, the company will give it to shareholders in the form of dividends, or the company can use that excess money to buy-back shares.
Next, is financing cashflow.
It tells us how much money the company has paid out in the form of dividends.
We can also check how much money the company has raised by selling equity or debt.
We can also see how much interest has been paid out.
We can also see how much repayment of borrowings has been done.
You have to look at all these numbers over a 10 year period and then sum them up, because every year they show how much cash is flowing through the business.
How do you calculate free cash flow?
Well, basically from the cash flow from operations, what you deduct is the capital expenditure.
From whatever you are left with, you have to deduct the interest expense and the repayment of borrowings.
Whatever is left over, is the free cash flow of the company.
This is the free cash which is available to the shareholders.
This money can be used to acquire other companies, make financial investments, pay dividends, do share buybacks, etc...
A company must produce a positive free cashflow, so that the management can do something with this cash.
The management can do something value accretive to the business.
If a company doesn't produce free cash flow at all, then where is the value for the shareholder.
This is the reason, I am looking at the cash flow statements over the past 10 years, to figure out whether the company is really making money or not.
Rohit Musale, CFA
27 December 2022