As I am writing this article, it’s the middle of August 2020 and COVID is in full force in the US. The question of ‘why is cash flow important?’ might seem pretty obvious, but I am here to tell you that it’s not as obvious as you might think!
The obvious answer is because cash flow is what you need to survive. When crap hits the fan, cash is what is going to keep you alive, right?
The immediate thing that comes to mind is the need for a company to have a set of reserves when they need that cash. For instance, as I am writing this in the Summer of 2020 and COVID is still ongoing, the need for companies to have lots and lots of cash has debatably never been higher.
The government is forcing companies to shut down in an effort to help slow the spread of COVID and it’s having a drastic impact on these companies. Sure, the government did have a first round of stimulus but now we’re here nearly a month after that stimulus has ended for individuals and that has a direct impact on the businesses as well.
Speaking of individual people – why do you have cash?
I have cash for two reasons only:
- I am going to make a short-term purchase
- In case crap hits the fan, I have an emergency fund
Those are the only reasons that I have cash.
I think that businesses generally are the same. They’re going to hold onto cash because they are nervous about the future and want to have their own emergency fund or maybe because they want to hold onto some cash to deploy it at a future time when the right time arises.
Maybe they’re waiting to do some major capex projects or maybe they’re looking to acquire a company – either way, holding cash will help them achieve those goals.
Some companies will hold cash because they don’t have anything better to do with it and as frustrating as that can be, a lot of people are the same way and just stash that money into a savings account that’s basically not earning any interest at all.
I mean, come on – if you’re going to put it into a savings account, at least try to put it in something like a high-yield savings account that’s earning a decent interest that mimics normal rates in the market!
But when I was listening to the Investing for Beginners Podcast, popular guest Braden Dennis brought up a great point that I didn’t really even think about.
Beyond just the short-term liquidity of a company (which can be evaluated with the current and quick ratio), Braden brought up that when companies are generating Free Cash Flow, that gives them the ability to really do 1 of 5 things:
- Hold the money
- Pay dividends
- Buy back shares
- Make an acquisition
- Reinvest that money back into the business
The first four make sense, and honestly so does the 5th one, but Braden brought up a really great thing to think about when you’re evaluating companies that you might want to invest in.
I’ve talked previously about how Braden is a huge fan of looking at the Return on Invested Capital (ROIC) of a company, which effectively shows how well a company is at putting their own cash to use and creating shareholder value, but when you can combine that with cash flow, then you have the mecca of all factors!
Two of his favorites are Visa and Mastercard, and I am personally a huge fan of both but mainly Visa, with a main reason being their strong ROIC.
Essentially, you’re going to start with net income and then add back in the things that don’t actually affect the true cash flow of the company. So, those things would primarily be depreciation and amortization because those aren’t actually impacting on the cash situation of the company.
Braden gives the best example that I think you could give on the podcast, but I figured it was so good I should note it below as well:
If you own a car, for instance, and you’re you that sits in your driveway, and it’s depreciating all the time. Sure. You know, the value, the car is lower next year. Totally. You’re, you’re using it. It’s getting older. So, you’re taking on that depreciation, but it’s not a cash transaction in your finances next year.
You didn’t have money that came out of your bank account because the car depreciated by $500, which was never a cash transaction. So that’s, that’s a real-life example of why we should have never taken it out.
Then we’re going to remove capex (PP&E) as well because, well, let’s just hear what Braden says:
If I have a manufacturing plant and I am going to build another manufacturing plant, why would I not be taking that out of the amount of cash that’s leftover at the end of the year, at the end of the quarter, if I have to build that, that is an investment that I, I need to make to grow the business.
So, basically what the goal of all of this is to find companies that not only have a great ROIC, and not only companies that have a great Free Cash Flow, but to try to find companies that have both!
If you can find companies that are generating a ton of cash and are extremely effective about taking that cash and creating value, then that is the type of company that I would want to be invested in.
I really want to challenge you to try to think outside the box. I recently talked about how in the past I have gotten really stuck on the numbers and it has hurt my investing growth because I have been so focused on the valuation ratios, I haven’t been able to think about the next steps.
To be a great investor, we need to think 2, 3, 4 steps beyond what others are doing. When you see COVID cases picking back up, maybe it’s a time to avoid some sports-based companies like gambling, equipment retailers, etc., that make their money based on sports being played.
At the same time, maybe you start to look harder at eSports and video game companies if you think that they might pick up some of the lost demand from actual sports.
It’s just about thinking a step or two beyond the normal, obvious info.
If you can do that and then combine that with some of the quantitative info, you’re going to be a force to be reckoned with in your investing journey!