As a financial metric, cash and cash equivalents should be the easiest for investors to understand. After all, we all have had cash at some point ourselves (and hopefully still do). However, with all of the focus on Wall Street on earnings, a metric like cash and cash equivalents can be overlooked and not thought about much.
Not thinking about a company’s cash can a mistake. Thinking about cash and cash equivalents in the wrong way can also be a mistake. Let’s break down this metric to its most basic form, and then use some common sense to think about what that number tells us at any given time.
Now, cash and cash equivalents shows ups in 2 financial statements: the balance sheet and the cash flow statement.
Most investors (amateur and professional) think about cash flow instead of cash, and use those metrics to create valuation models such as a DCF valuation.
Out of the 3 financial statements, the cash flow statement can seem like the hardest to understand—and this may contribute to the lack of interest in the cash and cash equivalents number itself. But just because cash and cash equivalents is ignored in a DCF doesn’t mean we should ignore it too.
The Cash Flow Statement Made Super Simple
To make it simple, let’s examine the flow of money through a business.
REVENUE —> EARNINGS —> CASH AND CASH EQUIVALENTS
Now, from revenue to earnings is where things to run the business get paid. So think like the workers, costs of inventory, etc. The day-to-day operations of the business, if you will.
Also, before the money is allowed to be called earnings (profit)– it has to be taxed, interest on debt needs to be paid, etc.
Where it gets interesting is how the earnings gets converted to cash.
Think of revenue to earnings being the difference between what you’re paid at your company and what you get as take home pay after the government taxes your income.
How earnings gets converted to cash is how your paycheck gets converted to your final checking account balance.
Your CHECKING ACCOUNT BALANCE = A company’s CASH AND CASH EQUIVALENTS
Since business is business and there’s lots of owners involved (shareholders), the money (in theory) should be spent to help the future of the business– whereas with your money you can blow it all for fun and that can be fine for you.
So, when earnings gets converted to cash, some investments for the company’s future are taken out of earnings first.
This is where you get financial jargon like…
“Capital expenditures” or “PPE” = assets for the business i.e. a new factory
“Marketable securities” = a company buying stocks / bonds just like we do
“Repayment of term debt” = paying back bondholders or other creditors
“Taxes” = on sale of investments rather than just on profits
“Share repurchases” = buying its own shares, pushing the stock price up
Also, the owners get paid at this stage. That’s where the dividends come out of…
And everything remaining after this becomes the company’s cash balance (CASH AND CASH EQUIVALENTS, also called CASH AT END OF YEAR).
These “withdrawals”, if you will, from earnings are outlined in the “investing activities” and “financing activities” portions of the cash flow statement.
Where it gets confusing is that the 3rd component of the cash flow statement, the “operating activities”, makes up part of that first flow (from REVENUE to EARNINGS)– just being more specific than the income statement. Also it doesn’t explicitly say “Net Earnings or “Net Income” in there, but the numbers add up the same.
What are the takeaways here?
Well as long as a company has healthy REVENUE to enable EARNINGS, and healthy EARNINGS to enable dividend payments and CASH AND CASH EQUIVALENTS, and enough CASH AND CASH EQUIVALENTS in case of a bad year, then future REVENUE can grow easier especially if large investments were made.
A beautiful cycle.
Devil’s Advocate: When Cash and Cash Equivalents Isn’t Important…
We can also deduce that CASH AND CASH EQUIVALENTS doesn’t matter that much.
Just because that number is low, doesn’t mean the company is doing bad. They could just be adding assets (marketable securities, property plant and equipment PPE), that will unlock future growth.
What does matter about CASH AND CASH EQUIVALENTS is that it’s there in case the company needs it (think bad economy or poor demand).
That way it won’t have to sell its assets (like long term stock investments), or take on more debt, to keep the business operating.
You certainly could examine each part of the cash flow statement, such as operating activities, financing activities, and investment activities, to really get down to the nitty gritty of how a company’s financials move through REVENUE –> EARNINGS –> CASH AND CASH EQUIVALENTS…
But if you just take the big picture, you can come up with pretty much the same conclusion.
3 Simple Ratios to Evaluate Flow of Money
Examining this flow of money is important to investors because it shows how well a company is compounding capital. If there’s any snag in the flow of money, it may indicate a stock that we don’t want to invest in until they fix that snag.
For example, if a company has high revenue but low earnings, the company has a profitability problem. Either they are wasting profits by having high costs, or their business model simply takes too many expenses to really be a profitable endeavor.
In either case, why endure the uncertainty of investing with such a company when there’s so many more out there that actually have a great flow of money through the business? I’d argue that investors shouldn’t have to endure subpar money flow. Here’s how we can identify it.
The P/S (price to sales) ratio tells us how much revenue (sales) a company has compared to how much you have to pay for a company. When a stock’s P/S is high, that tells us that either A) the stock price is high B) the sales is low or C) both.
Any of those 3 cases are subpar investment situations, and it only makes sense to avoid them. You want to pay less than a company’s intrinsic value, not more, and you want a company with high revenues rather than low—because even though high profits and low revenues mean high profit margins, profit margins tend to shrink over time as competitors enter the space. High profit margins attract competitors like moths to a light, and over many years and many industries the highest margin businesses eventually fell down to earth.
Investing during a time of decreasing profit margins can be painful, so the P/S can help avoid the companies solely relying on those margins.
The P/E (price to earnings) ratio helps us keep away from the problem I defined earlier—where a company isn’t profitable. A high P/E tells us either A) the stock price is high, B) earnings are low, or C) both.
Just like the P/S ratio, the P/E ratio shouldn’t be ignored because earnings are very important. Without earnings, you can’t have reinvestment into the business, which makes it very hard to grow the business at all, not to mention grow revenue and cash and cash equivalents.
Finally you have the P/C (price to cash) ratio to look at what we’ve been talking about today, the cash and cash equivalents. The reason we want to do is this that we want to see companies that have a back-up cushion for year where earnings might not be as great as normal. Earnings can fluctuate from year to year, and companies that adjust for that can give themselves more options when bad times come—rather than having those bad times compound into more bad financial consequences.
A high P/C tells us that either A) the stock price is high, B) cash and cash equivalents are low, or C) both. Like I mentioned earlier, a low amount of cash and cash equivalents might not be the worst thing in the world, but you don’t want to invest in a company with literally no room for error either. If the company carries a lot of debt already AND has hardly any cash and cash equivalents, the company is basically setting itself up for failure and should be avoided.
A sufficient cash and cash equivalents (through a low P/C ratio) can also signal that management is conservative enough with the way they spend earnings through reinvestment and dividend payments or buybacks. By showing restraint and carrying a cash balance, management shows they aren’t so desperate for stock price growth and/or business growth—and that they value stability. Those are qualities I find attractive in long term investments.
The 3 ratios are quick and simple ways to look at a company’s revenue, earnings, and cash and cash equivalents and get a great overall picture on the current health of a business.
By finding companies where cash is flowing smoothly into the business and out to shareholders in a stable process, your portfolio should also see a smooth compounding effect as your money is effectively and efficiently put to work.
It’s a simple idea and it doesn’t need 3rd degree algebra to examine. Yet it can be a worthwhile check throughout your investing career.