2.9. Cash Flow and Earnings Quality
Lesson objective
Confirm whether accounting profit converts into cash.
Net Income follows accounting rules and includes non-cash items. Operating Cash Flow adjusts those items and changes in working capital to approximate cash generated by operations.
Free Cash Flow is often calculated by subtracting capital expenditures from operating cash flow. It can indicate resources available for debt repayment, dividends, repurchases, acquisitions, or reinvestment, but definitions vary.
Persistent differences between profit and cash should lead to further review of receivables, inventory, stock-based compensation, and other adjustments.
Simple example
Microsoft showed higher Net Income and lower Free Cash Flow in the event reviewed. That divergence creates a question about investment spending and working capital.
Earnings quality: follow the cash
FCF = Operating cash flow − Capital expenditures(common definition)
Profit up, cash down
Net income rises from $100M to $130M, but OCF falls from $120M to $80M as receivables and inventory consume cash. The business may still be healthy, but the divergence needs an explanation.
Bridge: Net income → Non-cash items → Working capital → OCF → CapEx → FCF
Review receivables, inventory, deferred revenue, stock compensation, taxes, and one-time movements before judging earnings quality.
In Finzati
Finzati displays OCF, CapEx, and FCF in the financial statements and summarizes recent changes.
What you should remember
- Profit and cash are not the same.
- One weak FCF quarter may have temporary causes.
Practice
Compare Net Income and Operating Cash Flow over five years.