Last Thursday, we introduced the statement of cash flows and discussed the elements that comprise it. We'll look a little today at the value of cash flow in interpreting the financial health of a company, and also some of the drawbacks of traditional cash-flow based valuation.

If you were to look at a company the way an investment banker would, you'd be far more focused on cash flow than you would earnings per share (EPS) or net margins, which are what most financial headlines are centered on today. The reason for this is pretty straightforward: when you're about to float a boatload of cash for a chunk of the enterprise, you realize that the bottom line value of your ownership will be based on future cash flows.

The same holds true for individual investors, although not so much for short-term traders. If you're going to dig in deep and take possession on a company for the long haul, rather than tossing pieces of paper back and forth as if they were well-lubed basketballs, then you'll want to keep a keen eye on cash flows.

Cash flow is generally defined as earnings before interest, taxes, depreciation and amortization, or "EBITDA" (and all this time I thought that was an Andrew Lloyd Webber play). EBITDA focuses on the operating business, so interest income and expense, as well as taxes, are tossed in the dumpster like a twelve-day-old weather report. These are secondary costs that do not reflect operating results.

Depreciation and amortization are noncash charges, since cash does not change hands when they occur. Depreciation is the write-off for the reduction in usefulness and value of a long-term tangible asset and amortization is the write-off of an intangible asset over time. Both of these also fall outside of the operating business arena.

EBITDA will give investors an idea of how much money a company is generating before it meets up with the Taxman, Cousin Louie, or Mr. Drysdale (the banker) to settle up, and that can be useful. But it's not all good in the 'hood. If you focus on how much money a company makes, while ignoring things like capital expenditures, debt, and cash required for working capital, you may be missing some key and relevant information. If you base the valuation of a company on EBITDA and that company will continue to finance capital expenditures for many years to come, you're going to arrive at much too lofty a figure.

So, EBITDA, while worth examining in certain contexts, is a poor representation of cash flow. A much better number to focus on would be cash flow from operations, listed on the statement of cash flows. Even better yet is free cash flow, which is cash from operations minus capital expenditures. Free cash flow is the lifeblood of a business. It's what's left over when everything is reconciled and is available to pay dividends, make acquisitions, repurchase shares or throw one heckuva lawn party. Perhaps the best thing about free cash flow is that it is what is -- it can't be bent, folded, stretched or pureed like earnings so often are by crafty accountants.

Determining free cash flow is astonishingly easy. Let's crack open Yahoo!'s (Nasdaq: YHOO) latest cash flow statement and take a look. We'll look at just two lines:

Three Months Ended March 31
(All numbers in thousands)           2000    1999 

Net cash provided by operating activities 132,173 34,828

Acquisition of property and equip. (14,328)(11,608)

Remove capital expenditures from net cash from operating activities (add them together since expenditures are negative) and we end up with:
Free Cash Flow                     117,845  23,220

It's as easy as that. You have a quality measure of cash flow with which to gauge a company. Keep in mind, though, that in the early stages, promising young companies are scurrying to build out their business and therefore will often have disproportionate capital expenditures. Being in the investment stage of operations, you wouldn't want to get carried away scrutinizing free cash flow for these business, just as you wouldn't necessarily expect profitability right away.

We'll close here for tonight. Next week, we'll talk mo' about flow. To discuss this column, visit our Drip Basics discussion board linked below.

Drip on, Fools!

-- Vince Hanks, TMF Elwood on the Fool discussion boards