How to uncover a company that generates plenty of cash

Julie Brownlee, Fsp Invest, 12 Aug. 2014

Tags: cash, dividends, how to check a company generates cash, checking cash generation, profits, find a good stock to invest in, investment strategy

When it comes to investing, you want to put your money into companies that are highly cash generative.

If a company isn’t making enough cash, it’s just a matter of time before things start to go wrong.

So how can you check how good a company is at generating cash? Read on to find out…

A company must make good profits to survive

Any decent business must make profits. In other words, it must earn more in income than it pays out in costs.

But you need to be wary. Thanks to clever accounting practises, some companies can manipulate their profits. And they may give a false reflection of what’s really going on within the company.

To overcome this problem, you need to look at the ability of a company to generate cash. After all, no cash means no dividends.

If a company is struggling to make enough cash, there’s a higher chance of this turning out to be a bad investment. The company is at higher risk of going bust.

How to check how good a company is at converting profits to cash

You can do this by taking the operating profit number from a company’s income statement and the operating cash flow number from a company’s cash flow statement and comparing them.

For example, a company has operating profits of R100 million. It has operating cash flow of R80 million. That gives it a cash conversion ratio of 80%.

Another way to do this is to compare a company’s net profit with its free cash flow. That’s the profit for shareholders and the amount of cash a company has left over after its pays all costs and investments.

Sometimes there’s a good reason for a company’s cash flow being less than its profits for a short period of time. But if this happens frequently, it may be a warning signal that the company isn’t generating enough cash.

So there you have it, how to uncover a company that generates plenty of cash.

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