Show Me the Money, Kraft Foods

Although headlines still spray earnings figures all over the media every day, many investors have moved past net earnings as a measure of a company's economic output. That's because earnings are very often less trustworthy than cash flow, since earnings are more open to manipulation based on dubious judgment calls.

Earnings' unreliability is one of the reasons Foolish investors often flip straight past the income statement to eyeball the cash flow statement. In general, by taking a close look at the cash moving in and out of the business, you can better understand whether the latest batch of earnings brought money into the company, or merely disguised a cash gusher with a pretty headline.

Calling all cash flows
It's worth checking up on your companies' free cash flow (FCF) once a quarter or so, to see whether it bears any relationship to the net income in the headlines. That brings us to Kraft Foods (NYSE: KFT), which has produced $3,292 million  in FCF over the trailing 12 months, compared with $4,244 million in net income.

That means that Kraft Foods turned 8% of its revenues into FCF. That looks pretty good. But, it always pays to compare that figure with sector and industry peers and competitors, to see how your company stacks up.

Among its competitors and peers, beverage and snack specialist PepsiCo comes in with the highest FCF margin (defined as FCF / trailing 12 months' revenue), with 11% of its revenues turning into FCF. Kellogg, H.J. Heinz, and ConAgra Foods count down from 10%. Dean Foods and Smithfield Foods show us how tough the commodity consumer goods business can be.

All cash is not equal
Unfortunately, the cash flow statement isn't immune from nonsense either. That's why it pays to take a close look at the components of cash flow from operations, to make sure that the cash comes from high-quality sources. They need to be real and replicable in upcoming quarters, rather than being offset by continual cash outflows that don't appear on the income statement (such as major capital spending). For instance, cash flow based on cash net income and adjustments for non-cash income-statement expenses (like depreciation) is generally favorable. An increase in cash flow based on stiffing your suppliers (by increasing accounts payable) or shortchanging Uncle Sam on taxes will come back to bite investors later. The same goes for decreasing accounts receivable; this is good to see, but it's ordinary in recessionary times, and you can only increase collections so much.

So, how does the cash flow at Kraft Foods look? Take a peek at the chart below, which flags questionable cash flow sources with a red bar.

When I say "questionable cash flow sources," I mean line items such as changes in taxes payable, tax benefits from stock options, and asset sales, among others. That's not to say that companies booking these as sources of cash flow are weak, or are engaging in any sort of wrongdoing, or that everything that comes up questionable in my graph is automatically bad news. But whenever a company is getting more than, say, 10% of its cash from operations from these dubious sources, I feel obliged to crack open the filings and dig even deeper, to make sure I'm in touch with its true cash profitability.

With questionable cash sources comprising 11% of the cash flow from operations for Kraft Foods, I think it's time to do a little more digging. Most of this comes from changes in operating assets and current liabilities, swings that tend to work the other way around in later periods. (There are no free lunches, even from Kraft Foods.)

A Foolish final thought
If you take the time to read past the headlines and crack a filing now and then, you're probably ahead of 95% of the market's individual investors. By keeping an eye on the health of your companies' cash flow, you can spot potential trouble early, or figure out whether the numbers merit Mr. Market's pessimism. Let us know what you think of the health of the cash flows at Kraft Foods in the comments box below. Or, if you're itching to learn more, head on over to our quotes page on Motley Fool CAPS to view the filings directly.