Intermediate3 min readFundamental Analysis and Financial Statements · 14/15
Earnings Quality: Is the Profit Cash or Only Accounting?
Two companies report almost the same net profit. One actually banked the cash; the other's profit is still on paper. Earnings quality means seeing that difference before relying on the number.
What you will learn
Compare net profit with operating cash flow.
Know the most common reasons for a gap between them.
Tell a temporary, explained gap from a persistent one that deserves a question.
The lesson as a short video · 20 seconds · Watch on YouTubeIn this lesson
Compare net profit on the income statement with operating cash flow on the cash flow statement. High-quality profit turns into cash over time: across several periods operating cash flow should support accounting profit, though it need not match it year by year, since depreciation and working capital changes can separate them even in a healthy company. If operating cash flow is far below profit year after year, part of the profit is not reaching the bank.
ExampleTwo invented companies. Company A reports net profit of 93 million and operating cash flow of 103. Company B reports net profit of 100 million and operating cash flow of only 20. Open B's balance sheet and receivables rose 90 million in one year: most of its extra sales have not been collected yet.
Company A
Net profit
93
Operating cash
103
Cash exceeds profit
Company B
Net profit
100
Operating cash
20
Receivables up 90 million
Similar profit, very different cash.
Common reasons for a gap
Uncollected receivablesCredit sales count as profit today; the cash comes later, or not at all.
Piled-up inventoryCash spent on goods not yet sold.
Non-cash gainsSome fair-value or revaluation gains recorded in the profit and loss statement can raise profit with no cash coming in. Not every asset revaluation goes into net profit.
One-off gainsSelling land or a subsidiary. Real cash, but not from the normal business and not repeating.
How to judge
One year with a big gap can have an ordinary explanation: the company is growing and needs more stock, or a large client paid a few days after year end. What matters is the trend over several years. If cumulative profit is far above cumulative cash, that question needs an answer from the notes and the auditor's report.
Watch outA gap between profit and cash is not proof that something is wrong. It tells you to ask. Many sound companies show a temporary gap while growing; judgement comes after you know the reason.