In the quest to find great investments, most investors focus on earnings to gauge a company's financial strength. This is a good start, but earnings can be misleading and incomplete. To get a clearer understanding of a company's ability to earn money and reward you, the shareholder, it's often better to focus on cash flow. In this series, we tear apart a company's cash flow statement to see how much money is truly being earned, and more importantly, what management is doing with that cash.

Step on up, Illinois Tool Works (NYSE: ITW).

The first step in analyzing cash flow is to look at net income. Illinois Tool Works' net income over the last five years has been impressive:

 

2011*

2010

2009

2008

2007

Normalized Net Income

$1.6 billion

$1.4 billion

$0.8 billion

$1.5 billion

$1.6 billion

Source: S&P Capital IQ. *12 months ended Sept. 30.

Next, we add back in a few non-cash expenses like the depreciation of assets, and adjust net income for changes in inventory, accounts receivable, and accounts payable -- changes in cash levels that reflect a company either paying its bills, or being paid by customers. This yields a figure called cash from operating activities -- the amount of cash a company generates from doing everyday business.

From there, we subtract capital expenditures, or the amount a company spends acquiring or fixing physical assets. This yields one version of a figure called free cash flow, or the true amount of cash a company has left over for its investors after doing business:

 

2011*

2010

2009

2008

2007

Free Cash Flow

$1.3 billion

$1.3 billion

$1.9 billion

$1.9 billion

$2.1 billion

Source: S&P Capital IQ. *12 months ended Sept. 30.

Now we know how much cash Illinois Tool Works is really pulling in each year. Next question: What is it doing with that cash?

There are two ways a company can use free cash flow to directly reward shareholders: dividends and share repurchases. Cash not returned to shareholders can either be stashed in the bank, used to invest in other companies, or to pay off debt.

Here's how much Illinois Tool Works has returned to shareholders in recent years:

 

2011*

2010

2009

2008

2007

Dividends

$0.7 billion

$0.6 billion

$0.6 billion

$0.6 billion

$0.5 billion

Share Repurchases

$1.0 billion

$0.4 billion

NA

$1.4 billion

$1.8 billion

Total Returned to Shareholders

$1.7 billion

$1.0 billion

$0.6 billion

$2.0 billion

$2.3 billion

Source: S&P Capital IQ. *12 months ended Sept. 30.                       

As you can see, the company has repurchased a decent amount of its own stock. That's caused shares outstanding to fall:

 

2011*

2010

2009

2008

2007

Shares Outstanding (millions) 495 501 500 519 552

Source: S&P Capital IQ. *12 months ended Sept. 30.

Now, companies tend to be fairly poor at repurchasing their own shares, buying feverishly when shares are expensive and backing away when they're cheap. Does Illinois Tool Works fall into this trap? Let's take a look:

Itwbuybacks

Source: S&P Capital IQ.

Sure enough, Illinois Tool Works repurchased a lot of stock in 2007 and 2008 when shares were fairly high, and pulled back entirely in 2009, when shares were cheap. Whether this was a prudent way to save cash as it looked like the economy was about to implode, or a classic example of buying high and panicking low, is up for debate. In general, it doesn't appear management has been the most astute buyer of its own stock.

Finally, I like to look at how dividends have added to total shareholder returns:

Itwreturns

Source: S&P Capital IQ.

Over the last five years, Illinois Tool Works shares returned 22%, which drops to 7% without dividends -- not a bad boost to top off otherwise slow share performance.

To gauge how well a company is doing, keep an eye on the cash. How much a company earns is not as important as how much cash is actually coming in the door, and how much cash is coming in the door isn't as important as what management actually does with that cash. Remember, you, the shareholder, own the company. Are you happy with the way management has used Illinois Tool Works' cash? Sound off in the comments section below.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Motley Fool newsletter services have recommended buying shares of Illinois Tool Works. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.