Warren Buffett: This is How Companies Should Create and Spend Cash

Warren Buffett discussed corporate cash in his latest letter to Berkshire Hathaway (NYSE:BRKB) shareholders, a group that I am part of. Specifically, he focused on both the creation and use of cash. His commentary contained lessons that are applicable to all investors.

Regarding the creation of cash, Buffett said that not only is the Burlington Northern Santa Fe addition working out better than expected, but Berkshire has already refilled its coffers of the $22 billion spent on the acquisition–a sign of a good merger.

Though earnings make headlines, cash flow deserves considerably more attention than most people give it. Earnings are an accounting figure; cash flow is the difference between what a company brings in and what it spends. Well-run companies consistently generate cash over the long term.

How a company uses its cash is also very important. Buffett has long been an advocate for shareholders, criticizing CEOs for not being good wards of corporate cash. In this year’s letter, he pointed out that Berkshire only spent $301,363 on equipping the home office, an amount that includes the Coke (NYSE:KO) dispenser. He also, however, emphasized how critical it is to ensure that a company turns every dollar of retained earnings into two-dollar bills, not 50-cent pieces.

As Buffett explained, “This ‘what-will-they-do-with-the-money’ factor must always be evaluated along with the ‘what-do-we-have-now’ calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton (NYSE:WMT).”

This is why a high current ratio (current assets divided by current liabilities) raises my level of skepticism when I look at a company. Yes, companies should have adequate reserves and enough cash to take advantage of profitable opportunities, but not so much that a hole is burnt in the CEO’s pocket. I worry about excess cash because while some executives are very effective at redeploying cash or smartly deciding that a higher dividend is in the best interest of shareholders, many more aren’t. Corporate history is littered with failed projects and acquisitions that built empires for executives, but not value for shareholders.

Individual investors may have little say in how the money is spent, but they can vote with their feet. The cash flow statement will show you whether cash is being created or spent. I particularly look at cash from operating activities, which shows whether normal business operations are printing dollars or if there is a stream of smoke from the cash being burnt through. I also look at gross and operating margins to see if they are widening — good — or shrinking — bad. Even a quick glance at general and administrative expenses (G& A) can tell you if a company’s overhead is expanding at a faster pace than revenues (rarely a good sign).

Charles Rotblut, CFA, is a Vice President with the American Association of Individual Investors. His new book is Better Good than Lucky: How Savvy Investors Create Fortune with the Risk-Reward Ratio.