Quality of earnings

How reliably reported profit turns into actual cash, most simply measured as operating cash flow divided by net profit.

Example

Northgate's 225,000 over 345,000 is 0.65 - profit converted into cash at 65%.

Important

The ratio is a question, not a verdict. One low year during rapid growth is ordinary; a gap that fails to close across several years, each with its own reasonable explanation, is among the most reliable warnings in a set of accounts.

Related terms

• Operating cash flow — The cash a business generated or consumed by running itself, usually presented as net profit adjusted for non-cash charges and for the movements in receivables, inventory and payables.
• Net profit — What remains after every cost, including interest and tax, has been subtracted from revenue. The bottom line of the income statement.
• Accrual accounting — The convention under which revenue is recorded when it is earned and costs when they are incurred, regardless of when money actually changed hands.

Lessons that explain it

• The information request, and what a refusal tells you — What you ask for, and the order you ask for it in, determines what you learn. The response to the request is frequently more informative than the documents themselves. (13 min)
• Red flags: the signals that mean slow down — A red flag is not a reason to stop. It is a reason to stop moving at the speed you were moving, and to go and find out which of two explanations is the true one. (11 min)
• Not every number called revenue is the same kind of money — Financial diligence starts by separating recurring revenue from one-off fees, bookings from recognised revenue, and invoiced amounts from cash collected. (11 min)
• The real cost of running the company is often higher than the books show — Early companies often have below-market founder pay, unpaid invoices, deferred costs and free resources. Normalising the expense base shows what the company will actually cost to run. (10 min)
• Messy books are common; hidden liabilities are the real risk — Early companies often have informal accounting. Diligence separates harmless untidiness from problems that matter: unpaid taxes, related-party transactions, commingled spending and unrecorded obligations. (10 min)
• The entry multiple is set by auctions, and the fund's value by its own appraisals — Buyouts are priced as a multiple of earnings in competitive sales, and between purchase and exit the fund's value rests on appraisals that move far more smoothly than markets. (11 min)

All 578 terms in the Investing glossary