Reported profit depends on accounting estimates and judgements; cash is much harder to manipulate. Cash flow analysis examines how much cash a company actually generates and where it goes. Earnings quality asks whether reported profits are sustainable and backed by cash, or flattered by one-off items and aggressive accounting. Together they form one of the most important checks in financial statement analysis.
What you will learn
- Compare profit with operating cash flow using cash conversion and accruals measures
- Calculate free cash flow and see how it is used
- Recognise warning signs of low-quality earnings
- Combine the measures into an overall financial health assessment
Why profit and cash differ
Profit is measured on the accrual basis; cash flow records actual receipts and payments. The difference comes from non-cash items (depreciation, impairments, provisions) and from changes in working capital. The cash flow statement reconciles them. Over several years, a healthy business’s operating cash flow should broadly track its profit.
Key measures
Cash conversion and accruals
Cash conversion = Net cash from operating activities ÷ Net profit
Accruals ratio = (Net profit − Operating cash flow) ÷ Average total assets
Free cash flow (simple) = Operating cash flow − Capital expenditure
- Cash conversion around or above 1.0 over time suggests profits are backed by cash.
- A large, persistent positive accruals ratio means profit is running well ahead of cash — a classic sign of lower earnings quality.
- Free cash flow shows what is left for debt repayment, dividends and growth after maintaining and expanding the asset base.
Worked example: Company A’s cash quality
Company A (illustrative figures). Year 2 operating cash flow by the indirect method:
- Net profit 855 + depreciation 330 = 1,185.
- Receivables rose by 350 (cash absorbed), inventory rose by 400 (cash absorbed), payables rose by 200 (cash provided): 1,185 − 350 − 400 + 200 = 635.
| Year 1 | Year 2 | |
|---|---|---|
| Net profit | 750 | 855 |
| Operating cash flow | 900 | 635 |
| Cash conversion | 1.20 | 0.74 |
| Capital expenditure | 500 | 630 |
| Free cash flow | 400 | 5 |
Year 2 accruals ratio: (855 − 635) ÷ 7,500 average assets = 2.9%.
Where did the cash go in Year 2? Free cash flow of 5 could not cover dividends of 455 (equity rose from 3,800 to 4,200 while profit was 855, so 455 was paid out). The company borrowed an extra 400 and cash fell by 50: 635 − 630 + 400 − 455 = −50.
Profit grew 14%, but the company is borrowing to pay dividends while working capital absorbs its operating cash — a pattern that cannot continue indefinitely.
Warning signs of low earnings quality
| Warning sign | What it may indicate |
|---|---|
| Operating cash flow persistently below profit | Aggressive revenue recognition, slow collections or inventory build-up |
| Receivables growing much faster than sales | Sales on looser terms, or revenue that may not be collected |
| Inventory growing faster than sales | Slow-moving stock, possible future write-downs |
| Frequent "one-off" gains or "non-recurring" charges every year | Smoothing of earnings |
| Capitalising costs that peers expense | Inflated profit and assets |
| Changes in depreciation lives or other estimates that boost profit | Earnings management |
| Large related-party transactions | Revenue or costs not at arm’s length |
| Growing gap between EBITDA and operating cash flow | Working capital or quality problems |
| Supplier-finance arrangements reclassifying debt as payables | Operating cash flow and leverage flattered |
| Auditor changes or modified audit opinions | Disagreements or reliability concerns |
None of these proves wrongdoing; each is a reason to read the notes and ask questions. Many legitimate businesses — fast-growing ones especially — have temporarily weak cash conversion.
Sources and uses of cash
A useful exercise is to summarise several years of cash flows:
- Sources: operating cash flow, borrowing, share issues, asset sales.
- Uses: capital expenditure, acquisitions, dividends, buybacks, debt repayment.
A business that funds dividends and investment from operating cash is self-sustaining. One that relies on new borrowing or asset sales to fund dividends year after year is not.
A financial health assessment
Combine the analyses into an overall view:
- Profitability — are margins and returns adequate and stable? (profitability ratios)
- Cash generation — does profit convert to cash; is free cash flow positive?
- Liquidity — can short-term obligations be met? (liquidity ratios)
- Solvency — is debt sustainable? (solvency ratios)
- Efficiency — is working capital under control? (efficiency ratios)
- Distress risk — what does a model such as the Altman Z-score suggest?
- Quality — are there accounting or governance warning signs?
For Company A the conclusion would be: profitable and moderately leveraged, but cash generation weakened sharply because of working capital growth, and dividends are being funded by debt. The priority questions are collection performance, inventory saleability and the dividend policy.
Limitations
Cash flows can also be managed in the short term: delaying payments to suppliers, selling receivables or cutting essential investment can temporarily lift operating or free cash flow. Classification choices (for example, where interest paid is shown) differ between companies. One year is rarely conclusive; look at three to five years.
Common mistakes
- Treating EBITDA as a proxy for cash flow.
- Judging earnings quality on one year of data.
- Ignoring capital expenditure needed to maintain the business when assessing free cash flow.
- Assuming all accruals are suspicious — growth legitimately absorbs working capital.
Key terms
- Earnings quality — the extent to which reported profit is sustainable and backed by cash.
- Cash conversion — operating cash flow divided by net profit.
- Accruals ratio — the gap between profit and operating cash flow, scaled by assets.
- Free cash flow — operating cash flow less capital expenditure.
- Earnings management — using accounting choices to influence reported profit.
Frequently asked questions
Is low cash conversion always bad?
Not always. A fast-growing company may invest heavily in receivables and inventory. The question is whether the investment is earning a return and whether conversion improves as growth slows.
Can a company with negative free cash flow be healthy?
Yes, if it is investing in projects with strong expected returns and has secure financing. Persistent negative free cash flow without clear returns is a concern.
Which is harder to manipulate, profit or cash flow?
Cash flow is generally harder to manipulate, but timing and classification choices can still affect it in the short term.
Key takeaways
- Compare profit with operating cash flow using cash conversion and the accruals ratio.
- Free cash flow shows what is available after investment; check how it is used.
- Receivables and inventory growing faster than sales, and recurring one-off items, are warning signs.
- Combine profitability, cash, liquidity, solvency and quality into an overall health assessment.