Financial statements course · Lesson 9 of 10
Profit without cash is the first warning sign.
Accounting rules give management choices. Most choices are honest. The statements still show where profit and cash pull apart, if you know where to look.
Two companies, one profit
Example Co. B is a made-up copy of Example Co., with the same revenue and the same net income. But it gives its customers longer to pay, and it builds stock that it has not sold.
| Line | Example Co. | Example Co. B |
|---|---|---|
| Revenue | 1,000.0 | 1,000.0 |
| Net income | 137.5 | 137.5 |
| Receivables, end of year | 120.0 | 180.0 |
| Inventory, end of year | 90.0 | 130.0 |
| Days of sales in receivables | 43.8 | 65.7 |
| Days of inventory | 59.7 | 86.3 |
| Cash from operations | 185.1 | 85.1 |
| Free cash flow | 105.1 | 5.1 |
| Cash from operations per $1 of net income | $1.35 | $0.62 |
The income statements are the same. The cash is not. Example Co. B has $100 million more in receivables and inventory, so its cash from operations is $85.1 million. Its free cash flow is only $5.1 million.
The five signs
- Receivables grow faster than revenue. At Example Co. B, receivables grew 62% while revenue grew 8%. The company can sell to customers who cannot pay, or record sales too early.
- Inventory grows faster than cost of goods sold. Example Co. B’s inventory grew 56%. Goods that do not sell can lose value, and a write-down comes later.
- Cash from operations stays below net income. Example Co. B made $0.62 of cash for each $1 of profit. One year can have a reason. Several years in a row need an answer.
- Capex stays far below depreciation. For many years, this can mean that the company does not replace its equipment. Profit looks good until the bill comes.
- Adjusted figures pull away from GAAP figures. When the gap grows each year, read each adjustment. A cost that comes back each year is not a one-time item.
A sign is a question
Each sign has honest causes too. A company that enters a new market can build inventory before it sells. A company that sells to large customers can wait longer for its cash. A sign tells you which question to ask. Look for the answer in the MD&A and the notes.
Key points
- Profit and cash can pull apart. Working capital is the usual cause.
- Compare the growth of receivables and inventory with the growth of revenue and costs.
- A sign is a question. Find the answer in the MD&A and the notes.