How to find the best shares to buy by focusing on cash

Julie Brownlee, Fsp Invest, 07 Jul. 2015

Tags: best shares to buy, cash, cash conversion ratio, profitable shares, investing

To succeed over the long run, a company must be profitable. In other words, the money coming in must be greater than the money going out.

To check out the profitability of a company, you can’t just rely on its profit figures alone. With some clever accounting, a company’s profits can look better than they really are.

So it’s worthwhile having a look at the company’s cash situation.

Read on to find out how you can do this…

The best shares to buy generate lots of cash

To see how well a company is likely to do in the future and to help you find the best shares to buy, you need to look at how well a business generates cash.

For instance, if you’re investing for dividends, a company needs cash to pay them.

If a company struggles to make cash, it can get into financial difficulties and is at risk of going bust.

Checking how a company turns its profits into cash

So you need to work out how well a company converts its profits into cash. You just need two figures to compare:

  1. Operating profit number – from the income statement; and
  2. Operating cash flow – from the cash flow statement.

Say Company ABC has operating profits of R200 million. It has operating cash flow of R160 million. This gives it a cash conversion ratio of 80% ((R160 million/R200 million) x 100).

Another good comparison to make is using:

  • Net profit – profit for shareholders; and
  • Free cash flow – the amount of cash a company has left after paying all costs and making investments.

Sometimes companies go through periods when their cash flow is lower than at other times. But watch out if this happens a lot. It could be a warning sign as to what lies ahead.

So there you have it. How to find the best shares to buy by focusing on cash.

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