17.7. Compare Cash Flow and Profit

The objective of a business is not simply to make profit, but to generate cash flow from making profit as quickly as possible. Cash flow from making profit is the most important stream of cash inflow to a business. A business could sell off some assets to generate cash, and it can borrow money or get shareowners to put more money in the business. But cash flow from making profit is the spigot that should always be turned on. A business needs this cash flow to make cash distributions from profit to shareowners, to maintain liquidity, and to supplement other sources of capital to grow the business.

Businesses seldom offer any explanation of the difference between profit and cash flow. What you see in the statement of cash flows is all you get — no more. You're pretty much on your own to interpret the difference. There are no general benchmarks or ratios for testing cash flow against profit. I couldn't possibly suggest that cash flow should normally be 120 percent of bottom-line profit, or some other ratio. There is one rough rule: Growth penalizes cash flow — or, more accurately, growth sucks up cash from sales because the business has to expand its assets to support the higher level of sales.

Cash flow from operating activities can be a very low percent of profit (or even negative). This situation should prompt questions about the company's quality of earnings, which refers to the credibility and soundness of its profit accounting methods. In many cases cash flow is low because accounts receivable from sales haven't been collected and because the business made large increases in its inventories. The surges in these assets raise questions about whether all the receivables will be collected and whether the entire inventory will be sold at regular prices. Only time will tell. Generally speaking, you should be more cautious and treat the net income that the business reports with some skepticism.