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, Paychex (Nasdaq: PAYX).

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

 

2011

2010

2009

2008

2007

Normalized Net Income $529 million $489 million $456 million $524 million $516 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:

 

2011

2010

2009

2008

2007

Free Cash Flow $641 million $562 million $576 million $627 million $607 million

Source: S&P Capital IQ.

Now we know how much cash Paychex 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 to pay off debt.

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

 

2011

2010

2009

2008

2007

Dividends $457 million $449 million $448 million $444 million $414 million
Share Repurchases -- -- -- -- $1.0 billion
Total Returned to Shareholders $457 million $449 million $448 million $444 million $1.4 billion

Source: S&P Capital IQ.

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) 362 362 361 361 374

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

Editorial

Source: S&P Capital IQ.

Not great. All of Paychex's buybacks over the last five years came when shares were at or near a peak. Given fairly high valuations at the time, these buybacks probably weren't the greatest use of shareholder funds.

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

Editorial

Source: S&P Capital IQ.

Shares returned -22% over the last five years, which increases to -5% with dividends reinvested -- a nice boost 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 Paychex's cash? Sound off in the comment section below.