Cash flow is the amount of money a company takes in as a result of doing business. All companies take in cash, but some have to spend more than others to get it. This is a critical difference.
Let’s say Pig Iron, Inc. sells out its entire inventory of ingots and makes $100 million. That’s good. Then again, Pig iron, Inc. has to spend $80 million to keep the furnaces up-to-date. That’s bad. The first year Pig Iron doesn’t spend $80 million on furnace improvements, it losses business to more efficient competitors. In cases where you have to spend cash to make cash, you aren’t going to get very far. Companies like McDonal’s doesn’t have this problem. That’s why its preferable to invest in companies that don’t depend on capital spending.
There’s no point getting bogged down in calculating cash flow ratios. But if cash flow is ever mentioned as a reason you’re supposed to buy a stock, make sure that it’s free cash flow that they’re talking about. Free cash flow is what’s left over after the normal capital spending is taken out. It’s the cash you’ve taken in that you don’t have to spend.
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