In the quest to find great investments, most investors focus on earnings to gauge a company's financial strength. This is a good start, but earnings can be misleading and incomplete. To get a clearer understanding of a company's ability to earn money and reward you, the shareholder, it's often better to focus on cash flow. In this series, we tear apart a company's cash flow statement to see how much money is truly being earned, and more important, what management is doing with that cash.

Step on up, Microsoft (Nasdaq: MSFT).

The first step in analyzing cash flow is to look at net income. Microsoft's net income over the last five years has been impressive:

 

2011*

2010

2009

2008

2007

Normalized net Income $17.5 billion $16.8 billion $14.4 billion $14.8 billion $15.1 billion

Source: S&P Capital IQ. *12 months ended Sept. 30.

Next, we add back in a few non-cash expenses like the depreciation of assets, and adjust net income for changes in inventory, accounts receivable and accounts payable -- changes in cash levels that reflect a company either paying its bills, or being paid by customers. This yields a figure called cash from operating activities -- the amount of cash a company generates from doing everyday business.

From there, we subtract capital expenditures, or the amount a company spends acquiring or fixing physical assets. This yields one version of a figure called free cash flow, or the true amount of cash a company has left over for its investors after doing business:

 

2011*

2010

2009

2008

2007

Free cash flow    $25 billion $23.2 billion $18.7 billion $16.7 billion $19.7 billion

Source: S&P Capital IQ. *12 months ended Sept. 30.

Now we know how much cash Microsoft is really pulling in each year. Next question: What is it doing with that cash?

There are two ways a company can use free cash flow to directly reward shareholders: dividends and share repurchases. Cash not returned to shareholders can be stashed away in the bank, used to invest in other companies, or used to pay off debt.

Here's how much Microsoft has returned to shareholders in recent years:

 

2011*

2010

2009

2008

2007

Dividends $5.4 billion $4.8 billion $4.6 billion $4.2 billion $3.9 billion
Share repurchases $9.1 billion $15.3 billion $5.4 billion $14.8 billion $21.1 billion
Total Returned to Shareholders $14.5 billion $20.1 billion $10 billion $19 billion $25 billion

Source: S&P Capital IQ. *12 months ended Sept. 30.

As you can see, the company has been a prolific buyer of its own shares. That's caused its shares outstanding to plunge:

 

2011*

2010

2009

2008

2007

Shares Outstanding (Millions) 8,435 8,648 8,891 9,140 9,494

Source: S&P Capital IQ. *12 months ended Sept. 30.

Now, companies tend to be fairly poor at repurchasing their own shares, buying feverishly when shares are expensive and backing away when they're cheap. Does Microsoft fall into this trap? Let's take a look:

Msftbuybacks

Source: S&P Capital IQ.

Microsoft's share buybacks dried up in 2009 when its stock was dirt cheap, but in general the company has done a decent job with share repurchases. In relation to earnings power and cash flow, the company's stock has indeed looked cheap in recent years, so share repurchases have likely been an efficient way to reward shareholders.

Finally, I like to look at how dividends have added to total shareholder returns:

Msftreturns

Source: S&P Capital IQ.

Over the last five years, Microsoft shares have returned about 4%, which drops to negative 6% without dividends. I'd like to see management increase the company's dividend, but the amount paid out over the last few years has kept shareholder returns positive.

To gauge how well a company is doing, keep an eye on the cash. How much a company earns is not as important as how much cash is actually coming in the door, and how much cash is coming in the door isn't as important as what management actually does with that cash. Remember, you, the shareholder, own the company. Are you happy with the way management has used Microsoft's cash? Sound off in the comments section below.