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Wow, what a profit! But wait, where is the cash?

Profits that are not backed by cash flows tend to be misleading

Wow, what a profit! But wait, where is the cash?

Imagine a scenario where on the salary day, you receive a post-dated cheque, payable after a year, from your employer. Would you be happy? Likely not. Similarly, as a shareholder, you should not feel happy about a company that shows only profits but does not convert them into cash. A company's inability to convert its profits into cash in the long run may indicate corporate-governance issues. This inability is mainly due to a steady rise in working-capital requirements. And many times, a high receivables period is the prime reason.

The table lists companies that have shown profits over the last 10 years, but their total free cash flows are negative. Free cash flows are operating cash flows minus capital expenditure. They indicate that a company is able to take care of its capex requirements from the funds generated from business. Their working capital to sales ratio has also increased in three to eight years over the last 10 years. They also have high receivables when seen in terms of sales. Interestingly, their sales have also risen in at least seven out of the last 10 years.

Higher receivables with increasing sales - a common case with many of the following companies - is the result of rising credit-based sales. In such cases, sales are booked but actual cash is not received. It leads to an increase in the company's profit but its cash flow remains dry. At the same time, it also increases the risk of manipulation by the management.

Higher profits can also result in optically higher return on equity. But in the absence of sustainable cash flows, a high ROE is of little importance.