Last weekend, I was talking to a buddy who started a new business. I asked him how it was going.

“Sales are going great. But I have a cash flow problem. I have to turn away orders,” he said, shaking his head.

[ad#Google Adsense 336×280-IA]He explained that he can’t fulfill orders until he gets paid on older ones that have 30-day terms.

And if his customers are late paying the bills, he’s really stuck.

Let’s say my friend has \$1,000 in cash in the bank.

On July 1, he gets an order that will cost him \$1,000 to fill.

He spends the \$1,000, charges his customer \$2,000 and is paid on August 1.

Also on August 1, he gets an order for another \$1,000 worth of product (\$2,000 in revenue) and fills the order, leaving him with \$1,000 in cash.

On August 20, he gets a \$4,000 order that will cost him \$2,000. But he has only \$1,000 that he can use to buy the product that he’s going to resell. He can either borrow money or refuse the order.

You can see from this simple example how cash flow is the lifeblood of a business. If he doesn’t have enough cash coming in, he can’t buy enough product to make future sales.

As an investor, you also should care deeply about cash flow. Here’s why…

Let’s use the above example and pretend my friend is a publicly traded company.

The company fills the \$4,000 order on which it’s supposed to get paid on September 20. But the customer is late, and as of September 30, the company has not received payment. Its books close for the quarter on the 30th, and it reports results.

It booked \$8,000 in revenue – a \$2,000 order on July 1, another \$2,000 order on August 1 and \$4,000 on August 20. Its quarterly report will show \$8,000 in sales.

We know its cost of goods sold is 50% of its revenue. Let’s assume it spends another \$1,000 on sales, general and administrative. The company’s profit is \$3,000

But its cash flow tells a different story. Because cash flow shows investors how much cash came in the door or went out. Remember, the company is still owed \$4,000 from that August 20 order.

Its cash flow statement would look like this…

Someone could look at the company’s earnings and say it made \$3,000. But if you look at the company’s cash flow, you saw that \$1,000 more in cash went out the door than came in.

That can be a problem, especially when the company pays a dividend.

If this company paid \$500 in dividends, the investor has to wonder where that \$500 is coming from. After all, it didn’t come from operating the business. So it was either paid from cash on hand or the company had to borrow the funds.

This is a critical concept in my Safety Net columns, which run on Wednesdays. I want to be sure that any company that pays the dividend has the cash flow to back it up.

Of the nearly 1,000 stocks covered by SafetyNet Pro, my proprietary dividend safety rating system, 242 stocks have an F grade, which means there is a high likelihood of a dividend cut. There are many factors that go into the ratings, but an F usually means the company does not generate enough cash flow.

Let’s look at a few…

In 2016, Fastenal’s (Nasdaq: FAST) free cash flow was \$325 million while it paid shareholders \$347 million in dividends.

If the company isn’t able to get its free cash flow back above its dividend in 2017, management may have some tough decisions to make.

Last year, Cracker Barrel Old Country Store Inc. (Nasdaq: CBRL) generated only \$157 million in free cash flow. It paid \$256 million in dividends.

This year, free cash flow is forecast to decline all the way to \$104 million. If the company is going to sustain its dividend, it will have to borrow money or take cash out of the bank to pay it.

And L Brands (NYSE: LB), the owner of Victoria’s Secret, had only \$900 million in free cash flow, yet it paid shareholders nearly \$1.3 billion in dividends. Free cash flow isn’t expected to be above \$1 billion for the next four years.

I’ll tell you what Victoria’s secret really is: She can’t afford the dividend she’s paying.

Understanding cash flow is crucial to running a business and to analyzing a stock.

If you’re an income investor, you can’t afford to be unaware of whether your company’s cash flow will result in a dividend cut.

Otherwise, you could see a drop in your own cash flow.

Good investing,

Marc