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4 Reasons Why Cash Flow Is Key to Investing for Growth

How do I know if I am talking to a speculator, a trader, or an investor?

It is simple. I ask this question, ‘Do you look at a stock’s cash flows?’

Their responses would be different.

For instance, a speculator would give you a blank stare. A trader would say ‘No’ and dismiss its importance. Meanwhile, the one who says ‘Yes’ is an investor.

Why? This is because cash flow is key to separating stocks that have potential to grow in value from other stocks that do not. Stocks with positive and growing operating cash flows year after year are highly sought after by investors. Here’s why.

Cash Flows Fund Expansions

Stocks with abundance in cash flows have the flexibility to fund their expansionary activities and to invest for growth. To name a few, they include acquisitions of subsidiaries, associates, joint venture companies, new plants, new equipment, and new investment properties. These acquisitions would expand or create new streams of income to these stocks, thus, enhancing their value in the future.

Cash Flows Pare Down Debt

Debt costs money. Stocks with a lot of cash may choose to pare down their long-term borrowings to save future interest costs. This enables stocks to keep more of their operating profits and cash within its accounts. With that, these stocks could choose to invest this excess cash to generate higher profits, leading to a higher value to these stocks respectively.

Cash Flows Eliminate The Need For Rights Issue

I am not against rights issues. It is a method for stocks to raise capital without incurring interest costs from bank borrowings. I am fine with a stock issuing rights shares if it is done to finance its expansion plans and it is done once in awhile.

However, I do not prefer stocks which keep on raising cash from rights issues. This is because I believe a good stock is one that has the ability to raise cash from customers and not from investors. Also, stocks that keep issuing rights shares may have to offer these shares at discounted prices. Often, it is not a good thing to existing shareholders in the long run.

Cash Flows Pay Dividends

Stocks with an abundant cash flow have the flexibility to pay out growing dividends consistently to its shareholders. Thus, these stocks attract investors who invest primarily for dividend yields. In most cases, these investors could be larger and reputable financial institutions such as pension funds, mutual funds, and insurance companies who are risk-averse as they are serving the needs of millions of contributors. Thus, it explains why stocks that are cash cows and pay good dividends are demanded by a larger group of investors, which in turn, lead to higher market value of these stocks.

The Foolish Takeaway

In a nutshell, a stock that has potential to grow in value is one that has a solid cash flow management. Bad stocks are those with low cash balances and which need to borrow or raise equity constantly. Presently, there are plenty of stocks which are cash cows. Thus, there is no need for us to take unnecessary risks on stocks which have poor cash flow management.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.