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Cash Flow Provides Key Check Of A Company's Sales, Profits

Fund managers pay close attention to operating cash flow, which is a key measure of a company's ability to meet its obligations and invest for the future.

Individual investors should do the same.

Operating cash flow tracks money flowing into and out of a company's coffers from its normal operations. It's generally defined as revenue minus operating expenses such as wages, advertising expenses and utilities.

Though it's not a major indicator of a stock's health, operating cash flow can be used to double-check a company's fundamentals, since sales and profit figures can be manipulated.

For example, companies sometimes book sales when a contract is signed, before the money actually comes in. Such methods can distort sales and profit figures if, for example, a contract gets canceled.

During the Internet boom in the late 1990s, many start-ups reported strong gains in revenue. However, a look at their cash flow statements revealed that the revenue wasn't being generated by sales of a product. Rather, it came from borrowing, mainly from investors and banks.

When the funds dried up, the stocks collapsed.

A company's cash flow statement is usually broken down into three types: cash flow from operations, investing activities and financing activities. The cash flow from operations entry shows you how much money the company has on hand. It tells you whether revenue reported on the income statement has actually been collected. As such, it tells you how much money the company really has on hand.

In general, fast-growing companies should have operating cash flow per share that's at least 20% greater than the fiscal year's earnings per share. This is especially true for tech stocks. Keep in mind, however, that cash flow varies by industry, so it's important to compare a given stock against its peers.

Annual increases in cash flow per share are a good sign. They signal the company is managing its cash well and has enough money on hand to pay its bills, buy equipment, make acquisitions or buy back its own shares.

The accompanying chart shows a list of current IBD 50 stocks and their most recent annual operating cash flow-to-earnings ratios.

Public companies are required by law to report cash flow figures to the Securities and Exchange Commission. These are found in the companies' quarterly 10-Q filings and annual 10-K filings.

Cash flow statements also usually can be found on the company's own website and on some financial websites.

To calculate a company's cash flow from operations, take net income and add back non-cash items such as depreciation and amortization. The per-share number can be calculated by dividing the sum by the number of shares outstanding.