Small Cap Foolish 8 Consider Cash Flow

The final Foolish 8 screen requires small companies to show positive operating cash flow. This screen is somewhat redundant given the other screens for net profit margins and growth rates. Still, it's a smart idea for investors in small, rapidly growing companies to get familiar with the elements of the cash flow statement.

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By Brian Graney (TMF Panic)
March 4, 2002

This week's Foolish 8 column originally run on December 14, 2000. For more about the cash flow statement, see Jeff Fischer's Drip Portfolio column from last week.

In yesterday's column on the Foolish 8 screens relating to share price and relative strength, I went out on a limb and made the following statement: "[I]t is doubtful that a company growing earnings at a 25% clip and sporting at least a 7% net profit margin will not show positive operating cash flow." Quoting yourself is usually not a trait I admire in writers, but this line of thinking deserves some further clarification, especially in the context of a discussion about the Foolish 8 screen requiring small companies to show positive operating cash flow.

Given a fast-growing small company with solid net profit margins, isn't it a no-brainer that the firm will also show positive operating cash flow on its cash flow statement? In other words, isn't the positive cash flow screen redundant in light of the growth and margin screens already in the Foolish 8? My initial hunch was a resounding "yes" on both counts. What was needed, though, was some proof.

Hunches are never a good thing to rely upon exclusively when investing, whether you are trying to develop an individual investing philosophy or making a buy/sell decision for one of your stocks. As any married man can tell you, "going with your gut" and failing to back up a decision with some sort of reasoning can get you into trouble -- fast. One wrong hunch on the attractiveness of your spouse's new hairstyle or the importance of remembering an anniversary and you may find yourself spending the night on the couch with the dog. That some people forget that investing hunches need to be confirmed with facts and data as well is somewhat strange, considering the very high financial stakes that are often involved.

To back up my hunch on the redundant nature of the positive operating cash flow screen, I ran a screen at Quicken.com for all companies that sport at least a 7% net profit margin and year-over-year earnings and revenue growth rates of at least 25%. Quicken.com delivered a list of 427 companies, which I considered about right given that the same screen at other screening sites yielded similar numbers.

Next, I pulled up the latest 10-K annual reports for every single company on Quicken.com's list and tallied up how many showed negative operating cash flow in their most recently reported fiscal year. Yes, I actually did spend a whole working day checking the financials of all 427 companies (or at least the ones whose 10-Ks I could find.) No, it was not fun. But the result from my somewhat exhaustive, wholly unscientific operating cash flow study largely confirmed my hunch.

Out of the 427 companies that passed the margin and growth rate screening, 393 showed positive operating cash flow for the year and 34 showed negative operating cash flow. While I was honestly expecting an even higher spread in favor of firms with positive operating cash flow, the results appeared to confirm my hunch. This little exercise showed that greater than 90% of companies with at least 7% net interest margins and earnings and revenue growth of at least 25% also generate positive operating cash flow.

Of the 34 high-margin, fast-growing firms with negative operating cash flow, the large majority were financial companies of some sort. For these companies, the negative operating cash flow result appeared to be a one-time item, owing to a loan origination anomaly or an investment sale, for instance. My little study only turned up 10 non-financial firms where negative operating cash flow resulted from outsized changes in operating working capital accounts such as accounts receivable or inventory. Again, just 10 out of 427, or a little more than 2%! That's notable, since working capital swings can be a critically important issue for small companies.

The cash flow from the operating activities portion of the cash flow statement deals with two elements: adjustments to net income for noncash revenues and expenses and changes in working capital accounts. Both areas are worth paying attention to, but working capital changes are particularly relevant for investors in small, fast-growing firms.

Since the majority of the companies that pass through the Foolish 8 screens are in the early growth stages of their product life cycles, many will show significant increases in accounts receivables and inventories in order to keep up with their heady business growth.

Keeping these operating working capital items from spiraling out of control, as well as finding ways to fund them, are major issues for many fast-growing companies. Thus, working capital needs are something to keep an eye on and even to discuss with management in follow-up phone calls.

In sum, compared to the usefulness of the net profit margin and growth rate screens, the positive operating cash flow screen is an unequivocal dud at filtering out good small companies on its own. However, as with other Foolish 8 requirements that screen about as well Swiss cheese, this is not to say that the issue of operating cash flow is not important. It is, as is the entire cash flow statement itself. That's the main benefit of the positive operating cash flow screen -- it gets the small-cap investor's mind thinking about the cash flow statement, which is often treated like the neglected stepsister of financial statements.