This was originally published on RealMoney on April 17, 2007:

Financial Questions

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

portfolio management

(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.

It’s possible that management might let drop the anticipated rate of return on the new project, or even their target hurdle rates for new projects in general. You can ask for that figure, but don’t be surprised when you get turned down; rather, be surprised if you get it. I wouldn’t hand that information out if I were a company because competitors would like to know that information.

How is the turnover rate for your employees? How many suppliers have left you over the last year? What percentage of your business comes from repeat customers?

These questions can apply to any key relationship that the company has. If the company has difficulty retaining employees, suppliers or customers, that can be a warning sign. On the other hand, it is possible for the company to have too low a “quit rate.” This could imply that it isn’t extracting as much from the relationships as it possibly could.

Consider two examples for insight into how high and low employee turnover can affect a business. The first insurance company I worked for, Pacific Standard Life, had a 50% employee turnover rate. The place was a mess because institutional memory, particularly among mid- to lower-level employees, was forever disappearing. It was a wild ride for me, as the company grew by a factor of 10 in the 3½ years I was there, before it became insolvent in 1989 due to a bad asset policy forced on it by its parent company. (Trivia: At $700 million in assets, it was the largest life insolvency of the 1980s. The ’80s were kind to life insurers.)

Then there is a college that I know of that has a turnover rate of nearly zero. Many of the employees there stay because it’s the best place that would have them; they might not have other opportunities. As a result, productivity in some areas is low and new ideas are few.

A healthy organization tends to have at least 5% turnover. Depending on the industry, a turnover rate between 5% and 15% strikes a good balance between institutional memory and new ideas.

The same logic can apply to suppliers. Long-term relationships are good, but there is value in testing them every now and then to see whether a better deal can be struck in price, quality or other terms.

Repeat customers work the same way. Too low a repeat customer rate means that marketing costs will be relatively high. Too high a repeat customer rate, and the company might be missing out on additional profits from a price increase.

By David Merkel, CFA of alephblog