Chapter 5 · Day 5 — Cash flow and earnings quality
Operating cash flow, free cash flow, and earnings quality
The single most useful check in fundamental analysis: does the reported profit turn into cash?
Profit is calculated under accounting rules that involve judgement — when to recognise revenue, how fast to depreciate, what to provide for. Cash is counted. Where the two disagree, the disagreement is the story.
Where the cash went
| Section | Covers | Healthy pattern |
|---|---|---|
| Operating (OCF) | Core trading | Positive and near or above net profit |
| Investing | Capex, acquisitions, investments | Negative while growing |
| Financing | Debt and equity raised or repaid, dividends | Negative once mature |
Free cash flow
Free Cash Flow = Operating Cash Flow − Capital Expenditure. It is what remains for lenders and shareholders once the business has paid to keep itself running.
Worked: two companies, same profit
| Rs '000 | Company A | Company B |
|---|---|---|
| Net profit | 10,000 | 7,000 |
| Operating cash flow | 3,000 | 11,500 |
| OCF ÷ net profit | 0.30 | 1.64 |
| Capex | (2,000) | (3,000) |
| **Free cash flow** | **1,000** | **8,500** |
A reports the higher profit. B is the stronger business by a wide margin — it converts more than its whole reported profit into cash, and still funds its capex with room to spare. A is converting less than a third, which means the profit is sitting in receivables or inventory.
Negative is not automatically bad
- A hydropower company under construction has negative OCF and heavily negative investing cash flow — that is the business model, not a failure.
- A fast-growing trading company can have negative OCF because working capital is expanding.
- The question is always: negative because of growth, or negative because the core does not work?
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