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The Most Important Number to Look at Before Buying a Pot Stock

By David Jagielski – Feb 16, 2020 at 7:45AM

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The statement of cash flow is where you should start analyzing a company's results.

When a company releases its earnings report, two main items are typically the focus for analysts and investors -- revenue and earnings. While those are important numbers to keep an eye on, they may not be the most important, especially in the cannabis industry.

Revenue growth is important, but for companies to continue operating and growing, they need to be generating cash. That's why investors should always start with the statement of cash flow when assessing whether a stock is a good investment or not. In particular, one item should be the focus.

Cash flow from operating activities

At a minimum, a company should be generating positive cash flow from its day-to-day operations. If it's not bringing in more cash than it's spending, that's where investors can expect to see debt or equity issues and cuts to expenses, including job cuts. The severity of these decisions will depend on the long-term trending of operating cash flows. Working capital, for instance, can skew the numbers during a period if a company paid a lot of its liabilities down.

However, if a company is continually burning through cash from its operations, that's where investors need to assess whether it's a good investment or not. Take, for example, a company like Aurora Cannabis (ACB -3.85%) which in the past month announced 500 job cuts. In its most recent earnings report released on Feb. 13, Aurora used up 230 million Canadian dollars to fund its operating activities over the past six months. That's nearly double the CA$133 million it used up a year ago during the same period.

Cannabis leaf on top of a map of Canada.

Image source: Getty Images.

Operating activities don't factor in capital expenditures, which will only add to a company's cash needs. If Aurora had not disposed of marketable securities worth CA$84.8 million, the company would have burned through more than CA$475 million from its operating and investing activities combined. 

It's normally in the financing section where we see a company make up for this shortfall if it doesn't want to chip away at its cash balance. And indeed, during the past six months, Aurora has issued shares to generate CA$320.8 million and long-term loans which have brought in another CA$64 million in cash. 

The danger is that as its stock price continues to fall, issuing shares becomes less and less optimal. It'll lead to more dilution, as more shares will need to be issued to generate the same amount of cash as when the stock was performing better.

Why cash flow should take priority over other statements

The statement of cash flow is one area where a company's results are easy to follow. On the income statement, however, it's not uncommon to find nonoperating items and revaluation gains sometimes making a mess of a company's performance, and as a result, the numbers can be difficult to understand. When looking at cash flow, there are only three sections that investors need to focus on, and that can help minimize the complexity (especially since day-to-day operations are all grouped together).

The statement of cash flow can also be very useful in identifying problems that other statements won't uncover. Whether it's trouble collecting payments or spending too much on inventory, looking at cash flow can help investors track the movement of money, which isn't always clear when looking at an income statement or balance sheet.

Should investors avoid companies with negative cash flow?

For risk-averse investors, it's probably easiest to steer clear of cash-burning companies. Unless they're sitting on a lot of cash, like Canopy Growth from the $4 billion investment it received from Constellation Brands in 2018, a high rate of cash burn can create problems for investors down the road.

That's why many pot stocks are risky buys today, as many are burning through lots of cash. And while they may obtain funding in the short term, that's only a temporary solution. Until a company can become cash-flow positive, it won't be self-sustaining, which can lead to debt, dilution, and all sorts of bad words for investors.

Whether you're investing in Aurora, Canopy Growth, or any pot stock, you should always consider their operating cash flow. It could help uncover other problems in the business and help you decide whether the potential rewards are worth the risk.

David Jagielski has no position in any of the stocks mentioned. The Motley Fool recommends Constellation Brands. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Aurora Cannabis Stock Quote
Aurora Cannabis
ACB
$1.25 (-3.85%) $0.05
Constellation Brands, Inc. Stock Quote
Constellation Brands, Inc.
STZ
$234.74 (-1.14%) $-2.69
Canopy Growth Stock Quote
Canopy Growth
CGC
$2.78 (-8.46%) $0.26

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