When marijuana companies report their earnings, the focus for investors typically goes to how much their sales grew and how profitable the businesses are. It's not often that these companies do well on both the top and bottom lines -- especially given the youth of this industry, which is still in its early growth stages. However, investors need to look beyond just those two areas.

What's arguably more important than revenue growth and profitability is cash flow from operations. The reason is that if a company is burning through cash from its day-to-day activities, it can be a sign that share issues and dilution are inevitable, which can offset any bullishness that sales and profit growth might generate. For cannabis investors, it can be a costly mistake to brush past the statement of cash flow.

Man working from home reviewing a sheet of paper.

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Poor cash flow can predict a need for share offerings

If a business is burning through cash instead of bringing it in, share issues might be inevitable. And news of an offering can be downright catastrophic. Cannabis producer Hexo (HEXO) announced a $140 million offering on Aug. 20, and the stock ended up crashing by more than 25% on the day.

But a quick look at the company's operations could have easily predicted this. In the trailing 12 months, Hexo burned through 18 million Canadian dollars just from its day-to-day operations. Although that might not seem like a huge amount, given that Hexo reported CA$194 million of cash on hand as of June 14 when it released its third-quarter results (period ending April 30), eagle-eyed investors would have noted that the company has been active in acquiring other marijuana businesses. 

Intent on becoming one of the top three companies in the Canadian pot market, Hexo has been bolstering its operations through acquisitions. One of the largest deals the company announced this year was its plan to buy licensed producer Redecan, which it says will put it "on the verge of [becoming] the no. 1 licensed producer by recreational market share." Hexo funded the CA$925 million deal through a combination of cash and stock.

There's no guarantee that Hexo is done, either. Even if it is content with its operations in Canada, it is also eyeing opportunities in the U.S. for when that market opens up (once the federal government legalizes pot). In May, Hexo announced it was acquiring a cannabis facility in Colorado. And while the cost was modest at just $6 million, the cost to retrofit and upgrade the facility could run Hexo close to $50 million.

For a business that isn't generating positive cash from its operations, these types of deals can spell problems down the road.

Should investors avoid stocks that have negative cash flow?

If you're a risk-averse investor, you should definitely steer clear of stocks that are growing their operations but also burning through cash. Hexo and marijuana producer Aurora Cannabis (ACB -1.80%) are two companies that often dip into the equity markets to raise money. And since 2020, both have been among the worst investments in the industry, down more than 60%:

HEXO Chart

HEXO data by YCharts.

It has been a bumpy ride for the cannabis sector, but the Horizons Marijuana Life Sciences ETF is still in a net positive position with returns of just over 1% during this time frame. The same cannot be said for these two cannabis operators.

Like Hexo, Aurora Cannabis has also been burning through significant cash; in the past four quarters, the company has used CA$280 million to fund its daily activities. And if you include investments in property and equipment, its cash burn rises to a negative CA$359 million. Even though Aurora hasn't been busy with acquisitions, the marijuana company's constant need for cash is evident -- when it announced a $300 million at-the-market offering program in May that would allow it to sell shares at its convenience, Aurora reported a cash position of CA$525 million, which isn't a terribly large buffer given its high rate of cash burn.

Both Aurora and Hexo are likely to issue more shares in the future, at least until they can start consistently generating positive cash flow. And while Hexo is closer to that state than Aurora, its thirst for acquisitions could negate that. Even if you believe the moves that both companies are making today will lead to positive results down the road, I'd argue there are simply better options out there for cannabis investors.