• Daywey Chen

Acceptable Cash Ratio > High ROE

Updated: Aug 14

When I look for good companies to invest in. One of the important factors that I look for is the company's cash flow. How much cash does the company have on hand? Is the company cash flow positive? Why? Because at the end of the day the company can have high ROE, high-profit margins but if they don't have enough cash on hand, then they have already lost the ability to operate.

Cash presents the ability of the company to be opened for business tomorrow. Without enough cash, there is no need to think about the future, because you have lost the ability to pay for your operation expenses. Will employee work for credit payment? Will the bank accept late debt payment? Will your landlord continue to rent for promised payment?

How much cash does the company has?

It is important to look into the future potential of the company. Does the company has the potential to grow and profit in the future is important. However, it is even more important to assess the company's ability to exist tomorrow. If the company can't survive through this year, what is the meaning to assess its potentials for the next 10 years? In fact many potential SMEs have gone out of business not because of their lack of innovation, not that their product sucks, not because their key staff have left. Merely, because they have ran out of cash!

Having an acceptable cash on hand its important. Please note that I have mentioned "acceptable", not "as much as possible". Too less cash puts the company in high operational risk. However, too much cash can mean that the company is not investing enough into the future. I tend to look for company that has a cash ratio around 2 (Cash ratio = cash / short term liabilities). There are people that are fine with cash ratio in the range of 0.5 to 1. However, I tend to take on less risk in my investments therefore I look for higher cash ratio of 2. Depending on your investment habits and the amount of risk that you are able to take on, the cash ratio that you look for will vary. However, I do not recommend companies with cash ratio that are less than 0.5.

Is the company cash flow positive?

Its best for company to be cash flow positive each year, meaning that it is receiving more cash than it is throwing out. However, it is not required in my investment portfolio. Sometimes the company can have delayed account receivables and a large amount of account payable due during the year. Or the the company could be making large investment for the future during the year. There are many factors that can cause the company cash flow to go negative. It its perfectly fine. However, this should not be a continuous trend. I tend to look for a 5 years cash flow sum. This means that I add up the cash flow figures for the past five years and see if it is positive? If it is negative, then I do not look further into it. If the company is positive over the recent 5 years then I look for the recent consecutive 2 years. Has the company been cash flow negative for 2 recent consecutive years? If yes, then I pass. If not, then its a company to consider to invest in for me.

Besides the the Cash ratio and the Cash Flow statement. I also evaluate a company base on its profit margin and its operating profit. I will share more on this topic in my next investment article.

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