A few weeks ago, we took a somewhat different look at the price-to-earnings ratio. The best way to use this basic tool is to think ahead and use next year's estimates to calculate a "forward P/E."

I mentioned in that column that the "earnings" part of the P/E ratio is nothing more than an accounting number and does not represent actual cash received. As part of Back-to-Basics week, we'll explore that concept further and learn which numbers do represent cash -- and thus are more important to an investor.

Net income
The fortunes of a stock seem to rise and fall on its reported earnings, or net income. Most of the time, businesses that handily beat earnings expectations see their stock rise, while those that miss estimates can expect to be taken down a few notches. And all this fuss over a number that's arbitrary and can be easily manipulated!

Dozens of calculations go into net income, and many of them have to be estimated. Additionally, expenses that are paid just once or twice a year -- such as insurance premiums -- are stretched out and reported on a pro-rated basis. As you can see, then, an annual cash payment of $1,200 can be made in January, but for purposes of calculating net income, only $100 of it will be marked as an expense in any given month.

This is just one example of how the actual cash that flows into or out of a business is different from what's reported on the income statement. Another is income that's recorded at the time of a sale, even though the payment for the transaction may be made months later. Why should we care about these differences? Because it's actually possible for a company to report positive earnings while strangling from lack of cash.

Cash from operations
If the income statement is a sort of fantasy, then where's the nonfiction section? Easy... just look to the cash flow statement. That's where you'll find exactly how much cold, hard cash flowed into and out of the business.

Let's use one of our Drip Port companies, Paychex (Nasdaq: PAYX), as an example. Below is a simplified version of the first part of its cash flow statement ("operating activities") for the just-completed fiscal year.

Consolidated Statements of Cash Flows for Operating Activities:

                            2002       2001      2000  
Net income                $274,531   $254,869   $190,007
 
Net cash provided by
operating activities       303,821    304,938    249,028

In Thousands
Year Ending May 31

The number we're most interested in is at the bottom: net cash provided by operating activities (some companies call this "net cash from operations"). In fiscal 2002, Paychex collected $303.8 million more in cash than it paid out. Unlike items on the income statement, what you see on the cash flow statement is pretty darned precise. There's not much that a less-than-honest company can do here to obscure the truth.

You'll note that Paychex's cash provided by operating activities was actually higher than its reported net income of $274.5 million. (You'll see that figure on the top line of the cash flow statement, but it's just carried over from the income statement.) It also had greater cash flow than net income in 2001 and 2000, as well. This is definitely something you want to see in companies you're invested in.

Free cash flow
We'll now move on to perhaps the most important measure of a company's true profitability: free cash flow. It's easy to calculate, and you should do so each and every quarter for any company you have an interest in.

Just below the "operating activities" section in the cash flow statement is "investing activities." You'll need to find a line called "purchases of plant, property, and equipment," or something similar. This is what's known as capital expenditures; it's the money spent on buildings and other major equipment that a company needs to run its business.

Here are the last three years' worth of capital expenditures for Paychex:

Investing activities 

                        2002      2001      2000
Purchases of property 
& equipment           (54,378)  (45,250)  (34,154)

To come up with free cash flow, just subtract capital expenditures from cash from operations. So for 2002, Paychex's free cash flow is 303,821 - 54,378  =  249,443. We'll round that to $249.4 million (remember, all numbers are reported in thousands, so add three zeroes to each).

Say what?
Let's think about why this number is important. We already know that the cash provided by operating activities is a legitimate measure of a company's profitability. However, a business has to regularly spend some of that cash on buildings and equipment. What's left over can be viewed as "free" cash available for any manner it sees fit: plowed back into the business, for example, or paid out as dividends.

Ideally, then, a company will not only generate positive free cash flow, but it will also increase its free cash flow each year. This doesn't mean you should entirely ignore net income and earnings per share; it's impossible to do so. Indeed, Wall Street seems to run on these numbers... flawed as they are. But always keep in mind that cash from operations and free cash flow show a company's true financial picture.

If you find topics like this interesting, or just feel you need to brush up on your investing skills, I highly recommend Choosing Stocks with The Motley Fool. The online seminar allows you to learn at your own pace... and you'll walk away from it with a solid investing foundation.

Rex Moore knows the pain of back bustin' like the farmer knows the pain of his pickup truck rustin'. His holdings and the Fool's disclosure policy can be viewed anytime.