A company’s ability to generate real cash seems to be as important as its revenues and profits combined (if not more important). This is especially true when we want to assess the financial stability and liquidity of the company. 

There is nothing extraordinary about a company declaring bankruptcy while simultaneously showing profits on paper, but bankruptcy is no longer possible when it has millions of dollars in its bank accounts.

Let’s use simple logic. When assessing the level of investment security, should we bet on a company that reports $100 million in profit in its financial statements but only has $1 million in its bank account, or rather on a company that reports $1 million in profit but has $100 million in its bank account? 

What should be considered more important from the point of view of the safety and stability of the company: the profit created by accountants shown in the financial report for the tax authorities or the actual amount of money in the cash register? Even if the answer may be subjective, it is indisputable that the risk of insolvency, bankruptcy, and collapse in the case of the second example company is much lower than in the case of the first.


Is all cash the same?

Having a large amount of cash in the company’s cash register does not automatically mean that buying its shares will be a great investment. As shareholders or investors, we do not become co-owners of a business so that its assets consist of unproductively lying cash in accounts. In this case, we might as well open a savings account or deposit in a bank and deposit our money there, and then watch it wither away in a low-interest account. 

By becoming shareholders of a company and investing cash in its shares, we rather expect that the company will manage its equity effectively over the years to ultimately generate even more cash for us. 

Therefore, it is equally important to check the flow of funds, i.e., where they came from and where they flowed in the meantime. In other words, studying cash flow means assessing where the company gets its money from and what it spends it on.

At first glance, it may seem less important how a company earns its money, as long as it earns. But what if the money in the company’s cash register comes from a loan taken out from a bank or from issuing bonds? Will the cash obtained in this way be as highly valued by shareholders as cash obtained from the sale of products manufactured by the company? 

And how should investors treat money that has greatly boosted the company’s accounts in a given year but came from the sale of part of its assets, such as land or real estate? Can such a cash inflow be maintained in the future? Should an investor even consider such an event as positive news? 

After all, the company did not generate this cash through operations, meaning it did not create it out of nothing but only exchanged one type of asset (land or property) for another. In the overall calculation, the additional cash in the account does not increase the value of the company in any way. 

Moreover, such a transaction may even reduce it over time because the property had a chance to appreciate in value, while the cash remains only cash. That is unless it is wisely invested, for example, in more efficient production lines that require less space to function correctly. In such a case, the sale of unnecessary buildings or land suddenly seems justified. 

Therefore, looking solely at the cash in the register, we cannot draw too many conclusions. 

That is why it is always necessary to examine the flow of funds reported in the financial statement. 


Operating activities and not

Cash in a company’s cash register can come from three sources: operating activities, financing activities, and investing activities.

Money generated from a company’s normal operating activities is the most valued and desired by shareholders. First, if we want to invest in the automotive industry’s development and invest in General Motors shares, we expect the company to allocate these funds to the production and sale of cars, not, for example, to grant loans. 

Second, revenues from operating activities must follow an upward trend, meaning that they must be higher each year for at least several recent years. As investors, we want to see that the company can not only stay on the market but also continuously generate more and more cash. 

Otherwise, why would we want to pay one dollar for a company’s shares in exchange for one dollar of cash generated by it? 

From an investor’s point of view, it makes more sense to invest money in a growth business that can generate more and more cash year by year than in a stagnant business. Stagnation of revenue growth or cash generation from operating activities often precedes the reversal of the growth trend. 

Thirdly, such activity is sustainable over time. It would be difficult to expect Apple to suddenly stop selling iPhones. If a company already has an established operating activity, this activity does not practically disappear overnight without warning, except for minor exceptions (Kodak, Nokia). 

On the other hand, it is easy to imagine that if the cash in the register comes from taking out loans, issuing bonds, diluting shares, or selling assets, these events are not long-lasting.


Cash from investments

The second source of cash in the register is investment activity, understood as the sale of the company’s assets. However, this does not refer to assets related to operating activities (e.g., finished products from the warehouse) but all others. These are often obsolete machines, worn-out production line components, used computer equipment, as well as land, real estate, or parts of the business. 

The process of selling these assets is not always a bad thing. If a company gets rid of outdated equipment and sells it on the secondary market to factories in less developed countries, and uses the cash obtained as equity to take out an investment loan to purchase newer and more efficient factory equipment, this news can be positive. Such expenditures are called capital expenditures for business development.

Another example may be the decision to sell a plot of land in the city center, which has been owned by the company for thirty years and where production activities have been carried out so far. If land prices in the city have risen by 500% during this time, the decision to sell the plot favorably and move production out of the city may be justified.

Hence, the phenomenon of obtaining cash from the sale of assets is not disqualifying in itself. 

However, it is essential to be aware that these are generally one-time activities and should not excite investors too much. Especially if we do not examine other transaction details or the company’s financial situation, as it may turn out that the company is selling assets to repay loan installments or pay its employees’ salaries. This news is terrible because it shows the management’s desperation and suggests that the company cannot efficiently conduct operational activities. 

All of this is presented on a platter in the financial statement, so it is essential to check it regularly, once a quarter.


Financial activities

The third source of money in a company’s accounts may be financial activities, understood as taking on debt, such as through bond issuance or the issuance of new shares. Diluting the shareholder base or increasing the level of debt should never be positive news at first glance, although… 

What if the company takes on 10 million USD in debt and effectively turns this money around in the next year, doubling its value and generating 20 million USD in profit? The following year, it doubles the capital again and achieves 40 million USD in profit, and in the next year – 80 million USD, and so on. In this case, was the initial decision to issue bonds and increase debt definitely wrong and irresponsible?

All the hypothetical situations mentioned above show that, both in relation to financial statements and the entire stock market, one should not draw hasty conclusions or evaluate data in isolation from the context without looking at a broader perspective on other data or indicators or without hearing the reasoning behind the management’s specific actions.

However, the universal and indisputable truth is that the more cash a company generates year by year, the more its share price will grow. Provided, of course, that we are talking about cash generated from operating activities, not from asset sales or taking out loans. This relationship is so obvious that it should not require any further explanation. With one caveat.


What about the free cash flow?

This passage discusses the concept of free cash flow (FCF). Free cash flow is the amount left over when cash inflows are subtracted from the company’s capital expenditures in a given period. 

For example, if a company receives 100 million USD in cash in a particular year and spends 80 million USD, the free cash flow amounts to 20 million USD. From a shareholder’s point of view, it would be ideal if this indicator also regularly increased. However, this is not necessarily the case.

Upon deeper reflection, one might conclude that if the company has more and more free cash flow year after year, the management simply has no idea what to do with this cash. 

Unproductive storage of money in a bank account is not a desirable solution from a shareholder’s perspective. After all, we do not become co-owners of a company to own cash stored in corporate bank accounts. We become co-owners of a company because we believe in the ability of its management to develop the business, create and launch new products, expand geographically, and so on. 

Therefore, a situation in which a company can generate more and more free cash but has no idea what to do with it next may raise some questions. Is the business stable? Has the company already saturated the market with its products? Has the scope for growth and building scale effect run out? Has the management become complacent?

Of course, it is good for every company to have a safety buffer in the form of excess unallocated cash, as such reserves help survive periods of lower sales and recession or deal with random events such as a factory fire or theft of goods. The presence of a safety buffer is highly recommended, but it may not always be justified to inflate it excessively. 

A more favorable situation would be when a company generates 100 million USD in cash from operating activities in the first year and spends 80 million USD, and in the second year, the proportions are 120:100, in the third 140:120, and so on, rather than if the proportions looked like this: 100:80, 120:80, 140:80. 

The constant increase of free cash flow in the register means that the company has not allocated it to pay off previously incurred liabilities, has not redistributed it in the form of dividends, has not repurchased its shares, and has not undertaken a whole range of actions that are crucial from a shareholder’s perspective. Instead, it has accumulated a stack of banknotes that it does not know exactly what to do with.

It would be difficult to say that such a situation (a large amount of cash in the register) is bad news for the company, but it certainly is not the optimal news from a shareholder’s perspective.