Talking to Management, Part 2: Gleaning Financial Subtleties

This column was originally published on RealMoney on April 17, 2007 at 10:00 a.m. ET. It's being republished as a bonus for TheStreet.com University readers. For more information about subscribing to RealMoney, please click here.

Editor's note: We're pleased to present David Merkel's five-part series on questions to ask the management of a public company. Each part covers a new set of issues and the reasons to raise them. In Part 1, Merkel explained the philosophy behind his approach and presented the big subjects he likes to get out of the way first. Now, in Part 2, he lists the questions he asks management to address his top financial concerns.

Financial Questions

What proportion of your earnings are free cash flow, available to be invested in new opportunities, stock buybacks, or dividends?

(Note: The free cash flow of a business is not the same as its earnings. Free cash flow is the amount of money that can be removed from a company at the end of an accounting period and still leave it as capable of generating profits as it was at the beginning of the accounting period. Sometimes this is approximated by cash flow from operations less maintenance capital expenditures, but maintenance capex is not a disclosed item, and changes in working capital can reflect a need to invest in inventories in order to grow the business, not merely maintain it.)

Again, a good analyst has a reasonable feel for the answer to this question. If management oversells its ability to deliver free cash flow, that's a red flag. With companies that I am short, I often ask about when they will increase the dividend or buy back stock. Alternatively, I ask about the prospective rate of return on their new projects, but more on that in the next section. You can ask a management team outright what proportion of the company's earnings is free cash flow and then analyze that for reasonableness.

As an aside, you can stay clear of a lot of blowups by avoiding companies that have strong earnings and weak or negative free cash flow. If a company has to plow a lot of cash back into the business to maintain it, it's often a sign of costs that aren't reflected in the current profitability of the business. At the edge, big deviations can indicate fraud; for example, I avoided investing money in Enron as a result of this analysis.

What's your best reinvestment opportunity for free cash flow? Or, what's your most promising new project?

Questions like this can flesh out the intentions of management and give longer-term investors a new avenue of inquiry in future quarters; follow up on the answers. The idea is to judge whether the new projects are valuable or not, or big enough to make a difference. Another thing that will be learned here is what time horizon management is working on, and whether the investments targeted are cash-consuming or cash-generating.