An intermediate investor is one who wants to move beyond index funds and pick individual stocks in an attempt to "beat the market" (as opposed to one's head). This means an investor is enthusiastic enough to devote at least a few hours a month to researching investments. One key part of that is gaining at least a basic understanding of financial statements. Once that happens, investors sing the tune of cash flow, and can understand what kind of returns a company generates on its assets and equity.

Free cash flow mojo -- Rex Moore (TMF Orangeblood)
Anyone moving beyond the beginning stages of investing should be familiar with the concept of free cash flow.  Free cash flow, or FCF, is the cash that's left over after all the bills are paid and all the equipment needed to run the business has been purchased. It's the lifeblood of a company, and something many investors use when trying to figure out how much a stock is worth.

FCF is calculated off of a company's cash flow statement. It's a simple equation: Just subtract capital expenditures (which could be listed as "plant, property and equipment" or some such) from cash provided by operating activities. (If you're scoring at home, you technically add capital expenditures to cash from operations since capex is a negative number.)

Phil Weiss tells all about calculating free cash flow in a Rule Maker column, while another esteemed Fool (heh heh) looks at eBay's(Nasdaq: EBAY) cash flow and its kissing cousin, the Cash King Margin. Finally, a book that will help you tie the cash flow statement to the balance sheet and income statement is John Tracy's How to Read a Financial Report.

Rex Moore (TMF Orangeblood) owns shares of eBay, which you can see on his profile .

Comparing cash flow from operations to net income -- Mike Trigg

As Rex said, investors should assess a company based on cash flow, not earnings. Earnings are reported in accrual accounting -- meaning revenue is recognized when earned -- while expenses are recognized when incurred, instead of when cash is paid. While this disparity allows companies to make their business look more robust on the income statement, the cash flow statement prevents such airbrushing.

One way to detect if companies have manufactured earnings is to look at the ratio of cash flow from operations (CFFO) to net income, which should equal at least 100%. This concept is outlined in Financial Shenanigans, by Howard Schilit, who discusses how companies distort their financial performance. Schilit states that a large net income can be validated by an equally high CFFO. If net income is high and CFFO is not, however, the quality of a company's earnings should be questioned.

Here's an example: Intermediate Inc., a fictitious company I've created, had CFFO of $12 million and net income of $10 million in 1999, giving it a solid CFFO to net income ratio of 120%. In 2000, it had CFFO of $10 million and net income of $15 million, dropping the ratio to 66%. Recognizing revenue before the cash was received and extending easier credit terms to customers was the cause for the decline and Intermediate Inc. ultimately went out of business the following year, leaving investors hung out to dry. 

Tracking the ratio of CFFO to net income can be a good first step when analyzing a company, but it's not as effective with young companies, which are forced to make large investments in working capital to grow their businesses. Working capital is the money a company invests in its business, so it can decrease CFFO. That makes the difference between CFFO and net income look more skewed. The ratio is a guideline that should lead you to examine a company's earnings more closely, particularly established firms that shouldn't incur sizeable inventory and receivables growth.

If you're ready to invest and just need some ideas of where to look, The Motley Fool Select is a good place to start. Get more details about our best stock ideas.

Mike Trigg (TMF Tonto) would steer clear of Intermediate Inc., preferring to go with extremes. He does own other stocks, though, which his profile reveals.

Return on equity, return on assets, and return on invested capital -- Paul Commins (TMF Buster)
Do we really need to compute Return on Equity (ROE), Return on Assets (ROA), and Return on Invested Capital (ROIC) to understand a company's performance? Isn't growth in earnings-per-share enough? And, if we must add these return ratios to the picture, can't we just pick one of the three to focus upon?

Well, the danger of an all-earnings focus is that a company can easily boost earnings per share by taking on debt to grow the size of the business, even if the business itself isn't very profitable. Perhaps the prototypical example is the rapidly expanding restaurant chain where the number of restaurants is growing rapidly, generating more and more profit, but the profit margin per restaurant isn't sufficient to pay the rapidly expanding debt tab and still leave a profit worthy of the investment risk.

Dave and Buster's (NYSE: DAB) is a classic example of this risky, high-growth restaurant strategy. There is little doubt that the business is growing and is profitable:

Fiscal  Sales   Earnings
Year   ($ mil)  Per Share
2001 $332 $0.95
2000 247 $0.76
1999 182 $1.04
1998 129 $0.77
1997 89 $0.58

But the cash generated from existing restaurant sales has not been sufficient to pay the tab for expansion and -- as a result -- debt is mounting (all table values in millions of dollars):

  Fiscal  Cash from  Capital  Outstanding
Year    Operations Spending Debt at YE
2001 $37 54 108 2000 25 74 91 1999 28 76 43 1998 16 40 12 1997 13 31 14 Total 119 274

Apparently, Wall Street isn't too thrilled with Dave and Buster's debt-fueled business plan. The fiscal year-end price for one share of stock has lost 36% over the last five years. How could you have seen this coming? Well, let's take a look at ROA and ROE:

          Return   Return
Fiscal    on       on
Year    Assets   Equity
2001 4.3% 7.8% 2000 4.1% 6.7% 1999 7.2% 9.8% 1998 6.9% 8.5%

As we can see, ROA, the basic engine of business performance, has failed to outrun much less risky money-market returns over this period. But by taking on debt, management has been able to "juice" the return on shareholder investments (ROE) in much the same way a brokerage margin loan boosts the performance of a profitable portfolio.

But remember the dark side of a margin loan. Debt payments come due, good times or bad, and if the basic business can't outperform the interest cost of the loan, you start losing money. Worst case, ROA trends into negative territory and debt leverage reverses its sway -- magnifying losses. The full Dave and Buster's story is yet to be written, but the share price trend suggests a Wall Street consensus that its prospects don't justify its risky plan.

Now, let's take a step back. Is all this ROE versus ROA stuff going right over your head? If so, read through our recent special on how the two are different, and then come back to this example.

On the other hand, maybe this explanation strikes you as superficial? If so, you're ready for the Dupont Equation and, if that goes down easy, it's time to digest Return on Invested Capital.

If you'd prefer to learn more by example, here's the latest Fool take on Dave and Buster's, which includes a link to a 1999 Fool's Duel on the company. For another restaurant chain example, we invite you to have a seat in the Rainforest Cafe.

Finally, if you are a newcomer to the world of corporate financial statements, you'll have to tackle the balance sheet to become a serious student of business performance. I agree with Rex: John Tracy's book How to Read a Financial Report is a good place to begin this stage of your development.

Best of luck to you, Fool!

Next: Advanced Investors »

Paul Commins (TMF Buster) doesn't own Dave and Buster's, but he does own other stocks, which you can find in his profile .

As always, The Motley Fool reminds you to do your homework before you invest. You can review our complete  disclosure policy  online.