A good company must make profits – its income must be higher than its costs. However, profits can be manipulated with clever accounting and may not reflect the underlying reality. Savvy investors will look at a company’s ability to generate hard cash, as this is what actually pays their dividends. Companies that aren’t good at generating cash can be bad investments and can go bust.
So making profits is one thing – but you want to know how well a company converts these profits into cash. You can do this by comparing the operating profit number from a company’s income statement with the operating cash flow number from its cash flow statement.
So if a company has operating profits of £100m and operating cash flow of £80m, it has a cash conversion ratio of 80%. You can also compare a company’s net profit (the profit for shareholders) with its free cash flow (the amount of cash left over after all costs have been paid and investments made).
There can be good reasons for cash flow falling short of profits for a short period of time, but big differences that happen frequently may be a warning sign – one that you should not ignore.