This week’s reading covers why Warren Buffet closely examines cash flow, the main differences between cash flow and future metrics such as net profit, and the importance of knowing where cash flow comes from.
Legendary investor Warren Buffett follows three fundamental principles when buying shares: long-term growth over short-term growth, investing in brands he understands, and focusing on cash flow, or “owner earnings.” Owner earnings are a measure of the company’s ability to generate cash over a period of time. It’s available cash that can be used instantly, whether for rent, utilities, payroll, etc. The more cash on hand a company has, the better. For example, if a company has invested too much in property, land, or equipment and suddenly must pay a vendor, it will be much harder to meet the vendor’s request. Therefore, it is optimal for a company to have cash for a vendor when they unexpectedly request payment. Buffett prefers looking at this metric because it is much harder for companies to “manipulate” their cash flow. In contrast, it’s much easier for companies to give favorable estimates based on net profit.
The three essential reasons cash and profit aren’t the same is because (1) revenue is booked at sale, (2) expenses are matched to revenue, and (3) capital expenditures don’t count against profit. Net profit is based on the promise of payment, so cash hasn’t changed hands yet. It normally takes businesses 1-2 months to pay an invoice. That means even though the sale can be recorded on an income statement; the company has to wait to receive the cash. Also, capital expenditures don’t count against profit. For example, a company can purchase a ton of machinery, and only a fraction of the cost will appear on each quarterly or yearly statement. Cash flow statements reflect all of these purchases as paid way before they’ve been fully depreciated.
It’s important to understand where cash flow comes from, whether from operations, investing, or financing. If cash flow comes from operations, that’s a good sign that the company generates cash from its products or services. If the cash flow comes from investing, it could mean one of two things: the company is growing, which results in increased revenues in the long term, or the company’s low level of liquidity makes it difficult to pay its expenses. If the cash flow is from investment, it may be an optimistic sign for the future, or it may also mean the company is selling stock to avoid going into debt/bankruptcy.
Works Cited
Berman, Karen. “Financial Intelligence, Revised Edition: A Manager’s Guide to Knowing What the Numbers Really Mean.” Google Play, Google, Jan. 2013, https://books.google.com/books/about/Financial_Intelligence_Revised_Edition.html?id=7TfCiz1LkMMC
Written by Mikael La Ferla
Mikael La Ferla 