subject: Cash Is King [print this page] When you choose stocks, it's important to know about the business's cash flow. You need to know how to measure it which will help you figure out whether the business is viable. Here's what you should think about in terms of cash being king when it comes to choosing to invest.
Heart beat, lifeblood
Little attention is usually paid to cash flow by the sharemarket but nevertheless it is one of the most important numbers to keep an eye on.
Generally, earnings or net income is the way that the sharemarket keeps score on success and failure.
So you can look at it this way: if the earnings of a company is the heart beat of the company, then cash would be the lifeblood of the business.
Cash in, cash out
Cash flow is about the cash moving in and out of a business. It's about the cash receipts and cash payments.
Any business owner would know that if you don't manage cash flow, you can find your business struggling to survive day-to-day.
So when it comes to the sharemarket:
1.How do you measure cash?
2.What ratios can help you? and
3.How do you tell when a company is in trouble?
Positive cash flow
Generally you want to see positive cash flow. Negative cash flow may not necessarily be a bad thing. But be careful because negative cash flow can be the precursor to a decrease in profit.
What it does mean is that you'll need to investigate further.
Financial strength ratios
The financial strength ratios are important as they allow us to evaluate the risk in an investment. That is, they help us evaluate the business risk that the company is taking.
Companies with less risk are more likely to survive difficult business conditions. In fact a weak financial strength ratio is not a problem when the company is producing great profits.
But it becomes a big problem once the company starts to hit a few bumps and gets into a little bit of difficulty.
There are many successful companies with weak financial strength and yet they survive off their strong profits.
One thing to keep in mind is that if this type of company starts to struggle, it is likely to get into trouble very, very quickly. As investors, we are likely to see dramatic changes being made to the business to help it survive.
Some changes that we may notice when a company gets into trouble are:
cancelled dividends
re-rating of debt
debt trading at a discount
negative cash flow
drastic cutbacks
There are many types of financial strength ratios. They include:
liquidity ratios such as the Current Ratio, Quick or Acid test ratio
risk or leverage ratios such as Debt to Equity and Interest Coverage.
These ratios are available for free from online brokers like Bell Direct.
Here's a quick guide on how to use them:
Very low riskLow riskNormalHigh riskVery high risk
Current ratioGreater than 2Greater than 1.20.9-1.1Less than 0.9Less than 0.6
Debt to Equity ratioLess than 20%Less than 35%35%-60%Greater than 80%Greater than 100%
Interest CoverageGreater than 7Greater than 53-5Less than 2Less than 1
So if you are looking at investing in healthy businesses, don't just look at the bottom line which is the most susceptible to manipulation. Make sure you also have a look at cash.
Cash flow tells you a lot about the company as a going concern as well as about the business' overall health.
