As an investor, you know that it pays to follow the cash. If you figure out how a company moves its money, you might eventually find some of that cash flowing into your pockets.

In this series, we'll highlight three big dogs in an industry and compare their "cash king margins" over time, as we try to determine which has the greatest likelihood of putting cash back in your pocket. After all, a company can pay dividends and buy back stock only after it's actually received cash -- not just when it books those accounting figments known as "profits."

The cash king margin
Looking at a company's cash flow statement can help you determine whether its free cash flow actually backs up its reported profit. Companies that can create 10% or more free cash flow from their revenue can be powerful compounding machines for your portfolio.

To find the cash king margin, divide the free cash flow from the cash-flow statement by sales:

Cash king margin = free cash flow / sales

Let's take Nike as an example. Over the past four quarters, the footwear giant generated $3.2 billion in operating cash flow. It invested about $335 million in property, plants, and equipment. To calculate the free cash flow, subtract Nike's investment ($335 million) from its operating cash flow ($3.2 billion). That leaves us with $2.8 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.

Taking Nike's sales of $19 billion over the same period, we can figure that the company has a cash king margin of about 15% -- a nice high number. In other words, for every dollar of sales, Nike produces $0.15 in free cash.

Ideally, we'd like to see the cash king margin top 10%. The best blue chips can notch numbers greater than 20%, a figure that makes them true cash dynamos. But some businesses, including many types of retailing, just can't sustain such margins.

We're also looking for companies that can consistently increase their margins over time, since doing so is an indication that their competitive position is improving. Erratic swings in margins could signal a deteriorating business, or perhaps some financial skullduggery. You'll have to dig deeper to discover the reason.

Three companies
Today, let's look at three companies in the wholesale-drug industry:

Company

Cash King Margin (Trailing 12 Months)

1 Year Ago

3 Years Ago

5 Years Ago

McKesson (NYSE: MCK)

1.6%

1.6%

1.6%

2.3%

AmerisourceBergen (NYSE: ABC)

1.0%

1.1%

1.4%

2.2%

Cardinal Health (NYSE: CAH)

1.9%

1.0%

1.0%

3.2%

Source: Capital IQ, a division of Standard & Poor's.

Cash king margins in the wholesale-drug business are thin enough to make even the best of the blue-chip retailers blush. McKesson has consistently given us cash king margins at less than 2%, with no growth in the past three years and a decline from five years ago. AmerisourceBergen has shown steady declines in its cash king margins, and only in the past four quarters has Cardinal Health boosted its margins. The decline in margins across these industry giants suggests increasing levels of competition, with slimmer margins as a result.  

The cash king margin can help you find highly profitable businesses, but it should be only the start of your search. The ratio does have its limits, especially for rapidly growing small businesses. Many such companies reinvest all of their cash flow into growing the business, and they're left with little or no free cash -- but that doesn't necessarily make them poor investments. You'll need to look closer to determine exactly how a company is using its cash.

Still, if you can cut through the earnings headlines to follow the cash instead, you might be on the path toward seriously great investments.

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Jim Royal, Ph.D., owns no shares in any company mentioned. Nike is a Motley Fool Stock Advisor recommendation. McKesson is a Motley Fool Stock Advisor pick. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.