Show Me the Money, Paychex

Although headlines still spray earnings figures all over the media every day, many investors have moved past net earnings as a measure of a company's economic output. That's because an earnings statement is very often less trustworthy than a cash flow statement because it's more open to manipulation based on dubious judgment calls.

The unreliability of the income statement is one of the reasons Foolish investors often flip straight past it and the balance sheet to eyeball the cash flow statement. In general, by taking a close look at the cash moving in and out of the business, you can get a better look at whether the last batch of earnings brought money into the company or merely disguised a cash gusher with a pretty headline.

Calling all cash flows
It's worth checking up on your companies' free cash flow (FCF) once a quarter or so to see if it bears any relationship to the net income in the headlines. That's what brings us to Paychex (Nasdaq: PAYX), which has produced $535 million in FCF over the trailing 12 months, compared with $477 million in net income.

That means that Paychex turned 27% of its revenues into FCF. That looks amazing. But, it always pays to compare that figure to sector and industry peers and competitors to see how your company stacks up.

Among its competitors and peers, Intuit comes in with the highest FCF margin (defined as FCF / trailing twelve months' revenue), with 29% of its revenues turning into FCF.

All cash is not equal
Unfortunately, the cash flow statement isn't immune from nonsense either. That's why it pays to take a close look at the components of free cash flow from operations to make sure these sources of cash are of good quality: In other words, that they're real, and replicable, in the upcoming quarters and not off-set by continual cash outflows that don't appear on the income statement, such as major capital expenditures. For instance, cash flow based on cash net income and predictable depreciation? Generally good stuff. An increase in cash flow based on stiffing your suppliers (by increasing accounts payable) or stiffing Uncle Sam on taxes? Those will come back to bite investors. The same goes for decreasing accounts receivable. This is good to see, but it's ordinary in recessionary times, and you can only increase collections so much.

So, how does the cash flow at Paychex look? Take a peek at the chart below, which flags questionable cash flow sources with a red bar.

I characterize as questionable cash flow statement line items such as changes in taxes payable, tax benefits from stock options, asset sales, and other items. That's not to say that companies booking these as sources of cash flow are weak or are engaging in any sort of wrongdoing. But whenever a company is getting more than, say, 10% of its cash from operations from these questionable sources, I feel obliged to crack open the filings and dig even deeper to make sure I am in touch with the true cash profitability.

With questionable cash sources comprising 12% of the cash flow from operations for Paychex, it's time to dig a little more. Checking out the latest statement, we see there are boosts from items such as litigation reserves. These are taken out of earnings but aren’t paid out yet. That’s a low-quality source of cash flow since it’s likely that money will need to be paid out in the future.

Foolish Final Thought
If you are the kind of investor who takes the time to read past the headlines and crack a filing now and then, you're probably ahead of 95% of the rest of individual investors out there. By keeping an eye on the health of your companies' cash flow, you can spot potential trouble early or figure out if Mr. Market's pessimism is warranted by the numbers. Let us know what you think of the health of the cash flows at Paychex in the comments box below. Or, if you're itching to learn more, head on over to our quotes page to view the filings directly.