Most accounting problems show up as a widening gap between reported profit and cash collected. A few ratios, tracked over time, catch the common ones.
12 min read · Level 3
I think the single most useful habit in reading statements is to put profit and operating cash flow side by side for several years and ask why they differ. Almost every accounting failure I am aware of was visible in that comparison before it was visible anywhere else, and it takes about two minutes.
Profit is an opinion shaped by accounting choices; cash is a fact. Most warning signs come from the two drifting apart.
Receivables growing faster than revenue. Days sales outstanding shows how long customers take to pay:
DSO = accounts receivable / revenue x 365
Year Revenue Receivables DSO 1 100,000 20,000 73 days 2 120,000 32,000 97 days
Revenue rose 20% while receivables rose 60%. The company is booking sales it has not collected, which can mean looser credit terms, customers in difficulty, or revenue recognised too early.
Other common signs:
Sign What it can indicate Inventory rising faster than sales products not selling, write-downs ahead Costs moved to the balance sheet expenses capitalised to flatter profit Operating cash flow below net profit for several periods earnings not converting to cash Frequent one-off adjustments recurring costs presented as exceptional Revenue concentrated in the last weeks of each period sales pulled forward Auditor or finance chief turnover disagreements over accounting
None is proof of anything. Each is a question: why did this happen, and what does management say?
Because the statements are where a business's condition shows before it appears in the story management tells. A company can report rising profit for several years while cash generation deteriorates.
It also gives a fair way to raise concerns. Asking why DSO rose 24 days is specific and answerable, unlike a general suspicion about the numbers.
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Two years of statements for the same company.
Item Year 1 Year 2 Revenue 100,000 120,000 Net profit 10,000 13,000 Operating cash flow 9,000 2,000 Receivables 20,000 32,000 Inventory 15,000 24,000
Profit rose 30%. Operating cash flow fell by 78% (from 9,000 to 2,000). Receivables and inventory together absorbed 21,000 of cash. The profit is real under accounting rules, and the company is nonetheless running out of money. The right question to management is what changed in credit terms and why inventory grew 60% on 20% more sales.
Reading the income statement alone. Profit can rise for years while the cash statement shows the business consuming rather than generating money.
Persistent gaps deserve an explanation; one-off differences often have innocent causes.
Compute them each period and look at the direction rather than the level.
Check what expenses are being moved to the balance sheet and whether the policy changed.
Raise the exact ratio and period with management rather than a general concern.
When analysing any company with published or provided financial statements over more than one period.
Do not treat a single period's movement as evidence of manipulation. Growing companies often consume working capital for entirely ordinary reasons.
Analyses of major accounting scandals and corporate collapses, including cases documented in regulatory enforcement actions and academic forensic accounting literature, have repeatedly noted persistent gaps between reported earnings and operating cash flow in the periods preceding the failure.
Track the profit-to-cash relationship over several years. Divergence is one of the earliest observable signals.
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