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, RLI (NYSE: RLI).                        

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

 

2011*

2010

2009

2008

2007

Normalized Net Income $124 million $112 million $83 million $67 million $159 million

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 $124 million $97 million $116 million $155 million $123 million

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

Now we know how much cash RLI 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, used to invest in other companies, or to pay off debt.

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

 

2011*

2010

2009

2008

2007

Dividends $31 million $30 million $23 million $21 million $20 million
Share Repurchases $7 million $24 million $19 million $48 million $133 million
Total Returned to Shareholders $38 million $54 million
$42 million
$69 million $153 million

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

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) 21 21 22 22 24

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 RLI fall into this trap? Let's take a look:

Rli Buy Back

Source: S&P Capital IQ. 

This doesn't tell us much. RLI's repurchases have been sporadic over the past five years, but its share price has been range-bound for most of that period, so gauging management's behavior toward market price is difficult. Given reasonable valuations in relation to book value and earnings, these buybacks have likely been a good deal for shareholders.

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

Rli

Source: S&P Capital IQ.

Shares returned 66% over the past five years, which drops to 24% without dividends -- a nice boost to top off already strong 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 RLI's cash? Sound off in the comment section below.