I've talked about cash flow quite a few times in this column. I think it's the most important metric you can use to evaluate a company.
But it's important that you not just take it at face value. You should understand
why cash flow (or any other variable that you use) is moving in the direction that it is.
If you went to the doctor with chest pains, he wouldn't listen to your complaint and then order you into surgery. While your chest pains may be a strong indicator that there is a problem with your heart, the doctor is going to want to find out exactly what is wrong with your heart (or even if it is in fact your heart that's causing the problem. It could have been the burrito you ate for lunch).
So when a company's cash flow goes lower, there can be all kinds of reasons. A very common one is because profits fell. That could be caused by lower sales, rising costs of raw materials or labor, and a host of other things that impact a company's bottom line.
One often overlooked reason that cash flow can be lower is
higher receivables.
At the end of this article, I'll share one stock that, following this metric, you might want to put on your radar.
First, the background...
When a company makes a sale, that sale is counted as revenue. The costs of goods sold is removed from the sale and you end up with the gross profit. After you count all of the other costs of running the business, you end up with net income.
But -- and this is a big but -- the company might not have actually received any money from its customer yet. Most companies pay on credit. The buy something, are sent a bill and pay it a few weeks or months later.
While the cash is still in the customer's hand, but after the sale has been made and recorded, it is labeled as accounts receivable.
Let's look at a very simplified example.
Say you have a company, and you made one sale this quarter for $1 million. Your cost of goods sold was $500,000. Your other expenses totaled $250,000. Your net income would be $250,000
However, you made the sale a week before the quarter ended, so you haven't received the $1 million yet, even though you counted it as a sale and showed a profit of $250,000.
When calculating cash flow, there are all kinds of things that get added back or subtracted to come up with the final total. Changes to accounts receivables, payables, inventory, depreciation, etc.
We'll again keep it simple and assume the only other item is the change to accounts receivable.
Because accounts receivable increased by $1 million, we subtract it from net income. An increase in receivables means we did not get the cash from some of the sales we made during the quarter. If receivables had gone down, we'd add it back in because it would represent cash that flowed into the business from previous quarters' sales.
It makes perfect sense when you think about it. You sold $1 million worth of stuff that cost you $750,000 to make and to sell -- $500,000 in cost of goods sold and $250,000 in other expenses. But you didn't actually collect any money yet. So you're in the hole by $750,000.
Next quarter, when you get paid the $1 million, it will be added to net income and your cash flow from operations will be higher. That also makes sense because you actually got paid the $1 million, so that is money that actually flowed into your business.
Accounts receivable can be tricky. Generally speaking you don't want it to rise too high because you want the company to be collecting the money on its sales, not waiting to get paid. But as in the example above, it can represent an increase in sales, so a temporary fall in cash flow when accounts receivables goes higher may indicate that business is actually picking up and the company simply hasn't gotten paid yet.
I ran a simple screen to test this theory. I screened for companies whose free cash flow (cash flow from operations minus capital expenditures) fell, while net income and accounts receivables increased. Just like our example above. I also required a $250 million market cap so as not to have the results impacted by volatile penny stocks.
Over the last eleven years, those companies generated a return of 99% versus the S&P 500, which was up only 18% during the same period. They outperformed the S&P in nine out of eleven years.
Let's look at an example from March of last year (so we can see how the stock performed over the course of a year)...
Lancaster Colony Corporation (NYSE:
LANC) grew net income to $35 million from $23 million. Free cash flow fell to $95 million from $122 million, while accounts receivable increased $88 million from $64 million.
The $24 million increase in accounts receivable made up 90% of the $27 million decline in free cash flow. Cash flow rebounded in 2011 and the stock gained 14.2% during the year, while the S&P rose 5.5%.
How about a company that matches the criteria today, that could outperform the market over the next year?
Take a look at
The Advisory Board Company (NYSE:
ABCO). The company provides research analysis to health care industry clients. Free cash flow fell to $38 million from $44 million last year. However, in the most recent quarter, net income jumped to $17 million from $9 million while receivables spiked to $235 million from $179 million.
As clients pay their bills, that's going to bring in a lot of cash to ABCO's coffers, and you should see cash flow rebound sharply.