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 importantly, what management is doing with that cash.

Step on up, Donaldson (NYSE: DCI).

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

 

2011*

2010

2009

2008

2007

Normalized Net Income $207 million $178 million $107 million $139 million $139 million

Source: S&P Capital IQ. *12 months ended Oct. 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 $172 million $162 million $227 million $154 million $74 million

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

Now we know how much cash Donaldson 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 in the bank, invested in other companies, or used to pay off debt.

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

 

2011*

2010

2009

2008

2007

Dividends $43 million $38 million $36 million $35 million $30 million
Share Repurchases $176 million $64 million $9 million $79 million $61 million
Total Returned to Shareholders $219 million $102 million $44 million $113 million $91 million

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

As you can see, the company has repurchased a decent amount of its own stock. That's caused shares outstanding to fall:

 

2011*

2010

2009

2008

2007

Shares Outstanding (millions) 77 78 78 78 80

Source: S&P Capital IQ. *12 months ended Oct. 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 Donaldson fall into this trap? Let's take a look:

Source: S&P Capital IQ.

Sure enough, Donaldson bought back a lot of stock in 2008 when shares were fairly high and pulled way back in 2009 as they cratered, only to come roaring back with buybacks as shares surged. Whether this was a prudent way to save cash as the economy looked about to implode or a classic example of buying high and panicking low is up for debate. In general, it doesn't appear management has been the most astute buyer of its own stock.

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

Source: S&P Capital IQ.

Shares returned 108% over the last five years, which drops to 97% without dividends -- a nice boost to top off already high performance.

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 Donaldson's cash? Sound off in the comment section below.