The Motley Fool is all about explaining complex financial issues in plain English. For investors, we've got a free Fool's School available to get you up to speed on investing basics. Other areas of Fool.com explain how to buy a home, find the right mortgage, and get your credit cards under control. We're convinced that, no matter how complex the financial issue, with a little guidance and a little common sense, you can work it out yourself.
Take corporate financial statements. When you're just starting out, you may not know which way is up on an income statement (hint: the bottom line goes down). But it's not as hard as it looks. Of course, it helps to start with investigating small companies with simple business models at first, simply because their filings are often easier to understand than are those of goliaths such as GE (NYSE:GE) or IBM (NYSE:IBM).
Apparel maker Cutter & Buck (NASDAQ:CBUK) is a good example of the kind of small business that any Fool can understand -- and the kind we research and recommend every month for investors who could use a helping hand, in our premier small-cap newsletter, Motley Fool Hidden Gems. Cutter reported its first six months of fiscal 2005 earnings yesterday, and they looked very good from a generally accepted accounting principles (GAAP) perspective. While revenues declined slightly since this time last year, profits per diluted share went the other way, skyrocketing 86%.
But there was one "but" in the story -- free cash flow, one of the Fool's preferred metrics of financial success, declined drastically (to $6.7 million from $16.2 million) even as GAAP profits increased. That's often a danger sign, suggesting that the earnings aren't as "real" as one would hope.
But take a closer look at the company's cash flow statement, apply a little logic, and you can see that the situation is not nearly as bad as the free cash flow numbers would suggest. We already knew that Cutter had a rough past few years, in which it built up piles of inventory and saw its CEO, chief operating officer, and chief financial officer all jump ship. Last year, Cutter tried to follow Gap's (NYSE:GPS) path to corporate redemption by, among other things, selling off surplus inventory to convert it into cash. The cash flow statement tells this story, showing that in the first half of fiscal 2004, Cutter converted $12.7 million worth of old shirts and slacks into new cash in the bank.
In contrast, with its old inventory cleared out and its business improving, this year Cutter had to spend $1.7 million to build its inventories back up. A year-on-year free cash flow decline resulted. But common sense says that this decline isn't likely to recur unless the company messes up and lets its inventories run rampant again.
Assuming it avoids that misstep, the company should end fiscal 2005 with about $13.4 million in free cash flow, giving it an enterprise value-to-FCF ratio of about 8.5 at its current price, and making it a fine candidate for a Motley Fool Hidden Gems recommendation.
For more coverage of Cutter & Buck, slip into these Foolish articles:
Fool contributor Rich Smith owns no shares in any company mentioned in this article.
