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, Marsh & McLennan (NYSE: MMC).                                                                                 

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

 

2011

2010

2009

2008

2007

Normalized Net Income $923 million $481 million $346 million $316 million $534 million

Source: S&P Capital IQ.

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. When a company runs a cash-flow deficit, money is pulled from savings, or raised through debt or equity financing:

 

2011

2010

2009

2008

2007

Free Cash Flow $1.4 billion $451 million $335 million $554 million ($681 million)

Source: S&P Capital IQ.

Now we know how much cash Marsh & McLennan 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 and assets, or used to pay off debt.

Here's how much Marsh & McLennan has returned to shareholders in recent years:

 

2011

2010

2009

2008

2007

Dividends $480 million $452 million $431 million $412 million $413 million
Share Repurchases $454 million $145 million $33 million $39 million $1.3 billion
Total Returned to Shareholders $934 million $597 million $464 million $451 million $1.7 billion

Source: S&P Capital IQ.

The company has repurchased a decent amount of its own stock. But combined with other rounds of share issuance, shares outstanding have actually increased:

 

2011

2010

2009

2008

2007

Shares Outstanding (Millions) 542 540 522 514 539

Source: S&P Capital IQ.

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 Marsh & McLennan fall into this trap? Let's take a look:

Mmc

Source: S&P Capital IQ.

Not great. M&M repurchased a lot of its stock in 2007, when shares were fairly high, pulled way back as they fell during the financial crisis, and came back with buybacks after shares rebounded. Whether this was a prudent way to save cash as it looked like the economy was 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, we like to look at how dividends have added to total shareholder returns:

Mmc

Source: S&P Capital IQ.

Shares returned 1% over the past five years, which increases to 19% with dividends reinvested -- a good number to top off otherwise low 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 Marsh & McLennan's cash? Sound off in the comments section below.