Chapter 15 · Cash Flow
Quality of earnings
The single most reliable warning in any set of accounts is profit rising while operating cash flow falls.
Profit and operating cash flow measure the same activity in two different ways. Over time they should move together. When they separate persistently, one of them is wrong, and it is almost never the cash.
| Pattern | Likely meaning |
|---|---|
| Profit up, operating cash up | Healthy. The profit is real. |
| Profit up, operating cash flat or down | Sales booked but not collected, or costs deferred. Investigate. |
| Profit down, operating cash up | Often a non-cash write-down. Frequently fine. |
| Both down | Honest deterioration. At least it is being reported. |
A simple ratio
Cash conversion = Operating cash flow ÷ Net profit. Above 1 means the business converts profit into cash and more. Persistently below 1 means reported profit is not turning into money.
The other reconciling lines are worth reading too. Large working capital changes explain most short-term gaps. Persistent negative swings in receivables mean the company is funding its customers.
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