Lesson 7 of 8
Profit and cash drifting apart
Operating cash flow against net income through a capacity build, the accrual ratio the product stores, and the year the gap closed the other way.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Operating cash flow divided by net income is stored here as the accrual ratio, and it can be far above one as easily as far below.
- Through a capacity build the ratio is usually high, because depreciation is a large non-cash charge added back.
- A ratio below one for several years is the forensic reading; a ratio far above one is usually the accounting of heavy fixed assets, not quality.
The accounting quality course reads this gap for signs that earnings are being managed. This lesson reads the same two numbers for a different purpose, and the two readings can point opposite ways at the same company.
Operating cash flow and operating income at one filer, four filed years
- Operating cash flow
- Operating income
Show the numbers
| Operating cash flow | Operating income | |
|---|---|---|
| FY22 | 15,181$m | 9,702$m |
| FY23 | 1,559$m | −5,745$m |
| FY24 | 8,507$m | 1,304$m |
| FY25 | 17,525$m | 9,770$m |
The two figures, and what separates them
Net income is an accrual figure. Operating cash flow is a cash figure. Between them sit the non-cash charges, of which depreciation is usually the largest at a capital-intensive company, and the movements in working capital.
ValueScreener stores the ratio of the two as the accrual ratio: operating cash flow divided by net income. It is deliberately the cash figure over the accrual figure rather than the other way round, so that a ratio above one means cash exceeded reported profit.
Why a capacity build pushes it up
Depreciation is added back in arriving at operating cash flow because it moved no cash. At a company whose asset base has grown for several years, the depreciation charge is large, so the add-back is large, and operating cash flow runs well above net income for reasons that have nothing to do with the quality of anything.
That is worth stating plainly because the accrual ratio is often introduced as a quality measure. Above one is not a mark of virtue at a heavy fixed-asset company; it is the arithmetic of the asset base.
The direction that does mean something
Below one for several consecutive years, at a company whose asset base is not shrinking, is the reading the accounting quality course is about. Profit is being reported that cash is not following, and the cash flow statement is the place to find which working capital line is absorbing it.
The habit this leaves you with
Before reading the gap as anything, ask what the depreciation charge is. At a company where it is a large share of revenue, the gap is mostly that charge and the reading has to be done on the working capital lines instead. At a company where it is small, the gap is working capital and the accounting quality reading applies directly.
The product stores a free cash flow conversion figure too, which divides free cash flow by net income and therefore has capital spending in it. At a company building capacity, that one falls while the accrual ratio rises, and the disagreement between the two is the most useful thing either of them says.
Check yourself
Why does the accrual ratio usually sit above one at a company with a large asset base?
- Because such companies manage earnings upwards
- Because depreciation is a large non-cash charge added back in arriving at operating cash flow
- Because capital spending is added back
Show the answer
Answer: B.
Capital spending is not in operating cash flow at all. The add-back is depreciation, and its size is a fact about the asset base.A filer reports operating cash flow of 1,559 million against an operating loss of 5,745 million. What is the most likely explanation?
- Earnings were understated
- A large depreciation add-back sitting on top of a loss, at a company that had been building its asset base
- An error in the cash flow statement
Show the answer
Answer: B.
The same add-back that raised the ratio in the profitable year raises it in the loss year. The direction of the gap did not change; the profit did.What does the disagreement between the accrual ratio and free cash flow conversion tell you?
- That one of them is computed incorrectly
- That capital spending is large, because it is in the second and not in the first
- That working capital moved
Show the answer
Answer: B.
Free cash flow conversion has capital expenditure in it. At a company building capacity the first rises while the second falls, and the gap between them is the spending.Sources
- Micron Technology, Inc., annual reports on Form 10-K for fiscal years 2022 through 2025, for operating cash flow and operating income: fiscal 2022 accession 0000723125-22-000048; fiscal 2023 accession 0000723125-23-000054; fiscal 2024 accession 0000723125-24-000027; fiscal 2025 accession 0000723125-25-000028.
- ASC 230, Statement of Cash Flows, for the treatment of non-cash charges in arriving at cash from operations.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The accrual ratio the product stores divides operating cash flow by net income. The comparison drawn above uses operating income, which is a different line, and the two are not interchangeable.
- A ratio computed against a negative denominator carries the sign of that denominator and should be read as an arithmetic artefact rather than a measure.
- Nothing here is a view on Micron or on any security.