Serious Money: The page on Buffett -- Part VI: Cashflow and debt

Warren Buffett speaks in northern Israel last September. These past weeks, the deteriorating stock market that responds to expectations of slower or no economic growth in 2008, continued high oil prices, sagging housing market, high debt consumers and the financial industry quagmire, got me thinking about "my pal Warren" again.

It's times like these, when we are looking for a solid footing in the investment world, the few people with positive track records -- measured in decades, not years -- are worth examining once more.

Last year I started a series of stories on Warren Buffett's very basic investment cornerstones. Buffett's Berkshire Hathaway (NYSE: BRK.A) has such a track record. Today, given how many companies are up to their penthouse executive suites in debt, I thought I would continue.

The subject of debt is a simple one. Companies that carry excessive debt on their books are not as good as companies that have cash sitting around. Debt can be a drag on earnings, reduce the company's flexibility and opportunity in a slowing economy, and has all the negative impacts to a company that it does to an individual household.

Is debt always bad? No. Sometimes it pays to take on some debt if money is cheap and a company has demonstrated that it can earn far beyond the cost of funds based on its proven return on invested capital. Sometimes, a company's stock is cheap and based on net profit margins being higher than interest rates and insider knowledge of the company's projections, it pays to borrow to buy back stock.

While high levels of debt are not a good sign in general, the levels of debt should not be viewed equally from industry to industry. For example, in real estate, a 50% long-term debt (loan-to-value) is considered quite conservative where it might be very high in an established software company where the common metric would be long-term-debt-to-equity.

Free cash flow (cash flow from operations minus capital expenditures) has been deemed by many to be the gold standard metric to measuring the profitability of a company's operations. Free cash flow does not tell the whole story, but it is harder to manipulate than net income or earnings per share. By establishing how much cash a company has after paying its bills for ongoing activities and growth, FCF is a measure that aims to cut through the arbitrariness and "guesstimations" involved in reported earnings. It signals a company's ability to pay debt, pay dividends, buy back stock and facilitate the growth of business. For more specifics see Investopedia.

You can find more in Buffett's letters on the company's website, or refer to Everything Warren Buffett for this year's letter, and past years' as well.

Previous stories in the series:

Sheldon Liber is the CEO of a small private investment company and the principal for design and research at an architecture & planning firm. He writes the columns Chasing Value and Serious Money. Disclosure: I own shares of BRK.B.