Basic, lesson 1 of 3
Where profit and cash part ways
Net income is an opinion built from accruals. Operating cash flow is closer to a fact. The gap between them, and which way it trends, is the first thing an investor checks.
9 min, 3 checks
1The accrual gap
Revenue is booked when it is earned and costs when they are incurred, not when cash moves. That is the right way to measure performance, but it means every income statement carries estimates. Those estimates land on the balance sheet as receivables, inventory, prepaid costs, and accrued liabilities. When they grow faster than the business, profit is running ahead of cash.
Worked example
Kestrel Tools (made up), one year
- 1Net income $120m. Depreciation and amortization $40m.
- 2Receivables rose $30m, inventory rose $25m, payables rose $5m.
- 3Cash from operations: 120 + 40 - 30 - 25 + 5 = $110m.
- 4Capex $60m, so free cash flow is 110 - 60 = $50m.
Free cash flow is about 42% of net income. One year like that can be growth. Three years like that is a question for management.
Check 1
Net income is $80m, D&A $20m, receivables rise $15m, inventory falls $5m, and payables fall $10m. What is cash from operations, in $m?
2The accrual ratio
A quick way to size the gap is to scale it by the balance sheet, so you can compare years and companies.
Accrual ratio = (Net income - Cash from operations) / Average total assets
Near zero or negative is normal for a healthy company. A high and rising ratio means more of earnings is estimates.
Check 2
Net income $200m, cash from operations $120m, total assets $1,500m at the start of the year and $1,700m at the end. What is the accrual ratio, in percent?
3Read three years, not one
A single year of weak conversion often has a clean reason: a big order shipped in the last week, inventory built ahead of a launch, a tax payment timed oddly. What matters is the trend and whether the explanation changes each year. Add up net income and cash from operations over three to five years and compare the totals.
Check 3
Over four years a company reports $400m of net income and $180m of cash from operations, with capex steady. What is the most useful next step?
Terms in this lesson: Net income, Income statement, Balance sheet, Depreciation, Amortization, Capital expenditures.
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