What PetSmart Does With Its Cash

In the quest to find great investments, most investors focus on earnings to gauge a company's financial strength. This is a good start, but earnings can be misleading and incomplete. To get a clearer understanding of a company's ability to earn money and reward you, the shareholder, it's often better to focus on cash flow. In this series, we tear apart a company's cash flow statement to see how much money is truly being earned, and more importantly, what management is doing with that cash.

Step on up, PetSmart (NAS: PETM) .

The first step in analyzing cash flow is to look at net income. PetSmart's net income over the last five years has been impressive:

Source: S&P Capital IQ.

Next, we add back in a few non-cash expenses like the depreciation of assets, and adjust net income for changes in inventory, accounts receivable, and accounts payable -- changes in cash levels that reflect a company either paying its bills, or being paid by customers. This yields a figure called cash from operating activities -- the amount of cash a company generates from doing everyday business.

From there, we subtract capital expenditures, or the amount a company spends acquiring or fixing physical assets. This yields one version of a figure called free cash flow, or the true amount of cash a company has left over for its investors after doing business:

Source: S&P Capital IQ.

Now we know how much cash PetSmart is really pulling in each year. Next question: What is it doing with that cash?

There are two ways a company can use free cash flow to directly reward shareholders: dividends and share repurchases. Cash not returned to shareholders can be stashed in the bank, used to invest in other companies and assets, or to pay off debt.

Here's how much PetSmart has returned to shareholders in recent years:

Source: S&P Capital IQ.

As you can see, the company has repurchased a decent amount of its own stock. That's caused shares outstanding to fall:

Source: S&P Capital IQ.

Now, companies tend to be fairly poor at repurchasing their own shares, buying feverishly when shares are expensive and backing away when they're cheap. Does PetSmart fall into this trap? Let's take a look:

Source: S&P Capital IQ.

This doesn't tell us much. PetSmart's buybacks have been sporadic, but it doesn't look like market swings have dictated management's buyback behavior. Given reasonable valuations, these buybacks have likely been a decent deal for shareholders.

Finally, I like to look at how dividends have added to total shareholder returns:

Source: S&P Capital IQ.

Shares 62% over the last five years, which increases to 71% with dividends reinvested -- a nice boost to top off already strong performance.

To gauge how well a company is doing, keep an eye on the cash. How much a company earns is not as important as how much cash is actually coming in the door, and how much cash is coming in the door isn't as important as what management actually does with that cash. Remember, you, the shareholder, own the company. Are you happy with the way management has used PetSmart's cash? Sound off in the comment section below.

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At the time thisarticle was published Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel.Motley Fool newsletter services have recommended buying shares of PetSmart. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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