What Paychex 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, Paychex (NAS: PAYX) .

The first step in analyzing cash flow is to look at net income. Paychex'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 Paychex 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 Paychex 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 Paychex fall into this trap? Let's take a look:

Source: S&P Capital IQ.

Not great. All of Paychex's buybacks over the last five years came when shares were at or near a peak. Given fairly high valuations at the time, these buybacks probably weren't the greatest use of shareholder funds.

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

Source: S&P Capital IQ.

Shares returned -22% over the last five years, which increases to -5% with dividends reinvested -- a nice boost to top off otherwise low 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 Paychex's cash? Sound off in the comment section below.

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At the time thisarticle was published Fool contributor Morgan Housel owns shares of Paychex. Follow him on Twitter @TMFHousel.Motley Fool newsletter services have recommended buying shares of Paychex. Motley Fool newsletter services have recommended creating a write covered straddle position in Paychex. 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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