Part 4 · Cash flow statement: money that actually hit the bank account · Lesson 22
Checking earnings quality
Even with the same KRW 1.2 billion profit, profit that arrived as cash in the bank account and profit that exists only on the books weigh differently. Put three years of numbers side by side and measure earnings quality.
QToday's question
Both companies have been profitable for three years in a row. Yet one company's bank balance grows while the other borrows money every year. Why can't you see this difference from profit alone?
Profit is a number calculated under accounting rules, and cash is money that actually came in. In this lesson we build up step by step, starting with the habit of putting the two numbers side by side and ending with how to measure earnings quality using three signals.
MAPLearning map for this lesson
We build it up in three steps. At the end of each step, a 'Quick check' lets you test your understanding before moving on.
In Lesson 15 you filtered one-off gains out of net income, and in Lesson 7 you used days sales outstanding to see whether unpaid receivables are piling up. Then in Lesson 21 you followed how Dark Cloud Electronics runs out of cash even while profitable. This lesson ties these pieces into a single checklist. Start by recalling the 'profit account vs cash account' from Lesson 18.
- STEP 1 · Basic conceptsPut profit and cash side by side
Know what means, and calculate the difference between net income and operating cash flow () yourself.
- STEP 2 · Understanding the logicMeasure quality with three signals
Explain how solid earnings are using the , the growth in trade receivables and inventories, and the share of one-off items.
- STEP 3 · Real-world applicationJudge with a 3-year dashboard
Compare Robin Bakery and Dark Cloud Electronics on three years of numbers, and judge the earnings quality of four practice companies yourself.
STEP 1Put profit and cash side by side
This is the first step in measuring the 'weight', not the 'size', of profit. Start by writing the two numbers side by side on one line.
Net income on the income statement is a number calculated under accounting rules. Even a cake sold on credit is booked as sales, and an expense not yet paid in cash is booked as this year's expense. This approach is called accrual accounting. By contrast, operating cash flow () on the cash flow statement counts only the money that actually came in and went out of the core business. As you saw in Lesson 18, the two numbers are the same business seen through different glasses.
can be summed up like this: did profit come from the core business, can it recur every year, and did it come in as cash? If Lesson 15 covered the first and second (filtering out one-offs), the focus of this lesson is the third, cash.
An easy analogy · payslip and bank account
Imagine your payslip says KRW 3 million, but every month your company says "we'll pay you next month" and actually deposits only KRW 2 million. If you look only at the payslip (profit) there is no problem, but the bank account (cash) keeps running low. A few months is fine, but if it goes on for years, you should doubt the payslip.
The simplest tool for measuring the gap between the two numbers is . It is net income minus operating cash flow, and you can think of it as the part of profit that has not yet turned into cash.
Robin Bakery's operating cash flow of KRW 1.8 billion was built in Lesson 18 like this: take net income of KRW 1.2 billion, add KRW 1 billion of that used no cash, and subtract KRW 400 million for the increases in trade receivables (+KRW 80 million), inventory (+KRW 70 million), and other working capital, income taxes, etc. (+KRW 250 million). For a company with a lot of equipment, it is natural for operating cash flow to exceed net income thanks to depreciation. So a healthy manufacturer often has accruals that are negative or near zero.
Dark Cloud Electronics (fictional) is the opposite. Its year-3 net income is KRW 300 million, but its operating cash flow is −KRW 2.2 billion. Accruals are 3 − (−22) = KRW 2.5 billion, more than eight times its profit. That means most of the profit on the books is tied up in unpaid receivables and inventory piled up in the warehouse.
Quick checkA company has net income of KRW 2 billion and operating cash flow of KRW 500 million. What are the accruals, and what might you suspect?
STEP 2Measure quality with three signals
Accruals alone are not enough. Overlay three signals and you can see even 'why' cash is short.
Signal 1 · Operating cash flow to net income ratio
Accruals are an amount, so they vary with company size. To compare companies of different sizes, it is easier to convert to a ratio. In this course, operating cash flow divided by net income is called the . Above 1x, more cash came in than profit; below 1x, part of the profit has not yet turned into cash.
A ratio slightly below 1x in a single year is not an immediate problem. A large delivery at year-end may have briefly raised receivables, or inventory may have been stocked ahead of the peak season. That is why you look at the ratio over a trend of 3 or more years and the cumulative total. If three-year cumulative operating cash flow is steadily smaller than three-year cumulative net income, it is reasonable to suspect a structural reason why profit isn't turning into cash.
Signal 2 · Are receivables and inventory growing faster than sales?
The most common reason profit fails to become cash is that money gets tied up in two places. One is money not yet collected (), and the other is goods not yet sold (). As a business grows, it is normal for both to rise a little. The problem is when they rise much faster than sales.
| Fictional company | Sales growth | Receivables growth | Inventory growth |
|---|---|---|---|
| Robin Bakery, year 2→3 | +9.1% (110→120) | +8.7% (9.2→10) | +8.4% (8.3→9) |
| Dark Cloud Electronics, year 2→3 | +9.1% (220→240) | +56.3% (48→75) | +44.7% (38→55) |
Robin Bakery's three numbers move at almost the same speed. At Dark Cloud Electronics, while sales rose 9%, receivables rose 56% and inventory rose 45%. Converting to the from Lesson 7 makes the difference clearer. Robin Bakery is about 30 days, but Dark Cloud Electronics is KRW 7.5 billion ÷ KRW 24 billion × 365 ≈ 114 days. That means it waits nearly four months to be paid after a sale.
Inventory is viewed through . Formally it is cost of goods sold divided by inventory, but for a quick comparison between companies a simpler version, sales divided by inventory, is also used. With the simple version, Robin Bakery is 120 ÷ 9 ≈ 13.3 times, while Dark Cloud Electronics slowed every year from 200 ÷ 25 = 8 times to 240 ÷ 55 ≈ 4.4 times. That means the speed at which goods leave the warehouse has nearly halved.
Signal 3 · One-off share of profit
In Lesson 15 you filtered out non-recurring items such as gains on land sales or foreign currency translation gains. When judging earnings quality, ask the same question. If net income suddenly rises while operating profit stays the same, the increase usually came from non-operating items. Even if large, this kind of profit is unlikely to repeat next year, so it is considered low 'quality'. If the sale proceeds have not yet been received, the cash signal (Signal 1) worsens along with it.
Common misconceptions
- "If operating cash flow is lower than net income, it's accounting fraud?"
- No. A fast-growing company's receivables and inventory rise together, so cash can be lower than profit for a while. Signals only tell you 'where to read more closely'; they are not conclusions. However, if it goes on for several years and receivables grow far faster than sales, you should check the notes and the audit opinion (Part 6).
- "Lots of cash coming in always means a good company?"
- Even if operating cash flow is good, if all that money must be spent again on equipment, little is left for shareholders. That is why you look at free cash flow (FCF) from Lesson 20 together. Also, cash can be boosted by delaying payments to suppliers (trade payables), so look at movements on the liabilities side too.
- "It's enough if one year's numbers are good?"
- Earnings quality shows in the trend. More important than one year's good ratio is whether cumulative operating cash flow has kept up with cumulative net income over 3–5 years.
Quick checkSales grew 10%, but receivables grew 40% and inventory grew 35%. How has the operating cash flow to net income ratio most likely moved?
STEP 3Judge with a 3-year dashboard
Now let's gather the three signals on one screen. Switch companies and see for yourself how the traffic lights change.
Net income vs operating cash flow (KRW 100 million)
Earnings quality traffic lights
Both companies are fictional companies in this course. Robin Bakery's year 1 and year 2 net income and operating cash flow are new fictional numbers set in this lesson. The traffic light thresholds (a ratio of 1x, receivables growth at 1.5 times sales growth, and so on) are simple reference lines for explanation, not official standards.
Robin Bakery's operating cash flow is larger than net income in all three years, and receivables and inventory move at the same pace as sales. Its profit is small but of high quality. Dark Cloud Electronics is profitable all three years, yet its operating cash flow is more deeply negative every year. As you saw in Lesson 21, this company issued convertible bonds three times in two years to cover the cash shortfall. Looking only at profit, it is a 'profitable company'; looking at cash too, it is a 'company propped up by borrowed money'.
Judge for yourself
These are the three-year numbers of four fictional practice companies. Read each company and choose its earnings quality.
Find it yourself on DART
In the annual report, open two tables under III. Financial Matters → Consolidated financial statements. 1 Note 'net income' at the very bottom of the consolidated income statement for the current and prior periods. 2 Note 'cash flow from operating activities' at the top of the consolidated cash flow statement for the same two years. 3 Among the adjustment items below operating cash flow, find the 'increase (decrease) in trade receivables' and 'increase (decrease) in inventories' lines to see where money got tied up. 4 One report shows only two years, so open one more annual report from the previous year, or line up three years with III-1 Summary financial information. Check the number unit (KRW millions or thousands) above the table first.
How to use it in investing
| If you see this | First check | Where to look together |
|---|---|---|
| Net income up, operating cash flow down | Whether receivables and inventory are growing faster than sales | Cash flow statement adjustment items, Lesson 7 days sales outstanding |
| Net income suddenly surges | Whether operating profit rose too, or it is a one-off | Lesson 15 non-operating income and expenses, notes |
| Profitable but borrowings and convertible bonds keep growing | How many years operating cash flow has been negative | Lesson 21 insolvency despite profits, Part 6 disclosures |
| Operating cash flow steadily above profit | Whether it's thanks to depreciation or delayed trade payables | Lesson 20 free cash flow |
Not always. The normal range differs by industry. In order-based industries cash may come in first because of advances received, and in equipment investment periods working capital may rise briefly. Earnings quality signals are not criteria for picking or discarding a company; they are signposts that tell you which part of the annual report to read more deeply.
Quick checkA company's three-year net income is KRW 900 million, 1 billion and 1.1 billion, and its operating cash flow is KRW 1.2 billion, −KRW 300 million and KRW 2.7 billion. Is it fair to judge 'earnings quality is bad' from year 2 alone?
✓What we learned today
- Earnings quality is the degree to which profit comes in from the core business, repeatedly, and as cash. Look at the size and the quality of profit separately.
- Accruals = net income − operating cash flow. Robin Bakery was −KRW 600 million in all three years (cash above profit), while Dark Cloud Electronics grew from KRW 1 billion to KRW 2 billion to KRW 2.5 billion.
- Operating cash flow to net income ratio = operating cash flow ÷ net income is on the solid side if it is 1x or more for several years. Robin Bakery went 1.9 → 1.7 → 1.5x, while Dark Cloud Electronics was negative all three years.
- If receivables and inventory grow much faster than sales, that is a warning sign. At Dark Cloud Electronics, receivables grew 50–60% when sales grew about 10%.
- Don't judge on one year's numbers; look at at least three years side by side. Investment or seasonality can make cash low for a single year, but if it goes on for several years, the story changes.
If Part 4 checked whether profit is backed by cash, Part 5 measures 'how efficient' the profit is. In the next lesson we split Robin Bakery's 20% ROE, earning KRW 1.2 billion on KRW 6 billion of shareholders' money, into three pieces.
Quiz5-question quiz
Pick an answer and it's graded right away with an explanation.
Q1. Robin Bakery's year-3 net income is KRW 1.2 billion and its operating cash flow is KRW 1.8 billion. What are the accruals?
Accruals = net income − operating cash flow = 12 − 18 = −KRW 600 million (figures in KRW 100 million). A negative number means more cash came in than profit. 1.5x is the operating cash flow to net income ratio.
Q2. Which is closest to a description of high earnings quality?
Earnings quality looks at the source of profit, its repeatability and whether it converts to cash, not its size. Sales growth or a rising stock price is a different story from quality.
Q3. Receivables grew 56% and inventory grew 45% while sales grew 9%. What should you suspect first?
Receivables and inventory growing much faster than sales are a classic reason profit fails to become cash. Dark Cloud Electronics looked exactly like this.
Q4. What is a good habit when looking at the operating cash flow to net income ratio (operating cash flow ÷ net income)?
One year's ratio can swing because of seasonality or a big order. Only by looking at a trend of three or more years and cumulative totals can you tell whether it is structural or temporary.
Q5. Net income rose from KRW 500 million last year to KRW 1.9 billion this year, but operating profit and operating cash flow are unchanged. What is the most fitting reading?
If core operating profit and cash are unchanged but only net income jumped, it is likely a non-operating one-off such as a gain on land disposal. Filter it as in Lesson 15 and judge only on the profit that will repeat.
NextTerms · Next lesson · Related tools
The degree to which profit comes in from the core business, repeatedly, and as cash. If there are many one-off gains, or little cash comes in relative to profit, earnings quality is considered low.
AccrualsAccrualsNet income minus operating cash flow. It means the part of profit that has not yet come in as cash, and if it is large and keeps growing over several years, it is a signal to question earnings quality.
Operating cash flow to net income ratioOperating cash flow to net incomeOperating cash flow divided by net income. If it is 1x or more over several years, profit is coming in well as cash; if it stays below 1x or is negative, check whether money is tied up in receivables and inventory.
Inventory turnoverInventory turnoverCost of sales (or sales in the simplified formula) divided by inventories. It shows how many times the goods in the warehouse sell through in a year. A falling figure may signal unsold inventory piling up.
Cash flow statementCash flow statementA table showing the cash that actually came in and went out through operating, investing and financing activities over a period. Closing cash equals cash and cash equivalents on the balance sheet.
Net incomeNet incomeThe profit left after everything, including corporate income tax, is deducted. What remains after dividends builds up as retained earnings on the balance sheet, and dividing the parent's share by the number of shares gives EPS.
Trade receivablesTrade receivablesMoney owed for goods or services already sold but not yet received. If it grows much faster than sales, it can be a sign the company isn't getting paid.
InventoriesInventoriesRaw materials, work in progress and finished goods held for sale. They become cash only once they are sold and collected.
Days sales outstandingDays sales outstandingTrade receivables ÷ sales × 365. It shows the average number of days it takes to receive cash after a sale.
One-off itemsOne-off itemsGains and losses that don't repeat every year, such as gains on asset disposals, litigation payouts and impairment losses. When projecting next year's profit or calculating P/E, it is best to filter them out.
DepreciationDepreciationSpreading the purchase price of equipment over its years of use and expensing it each year. It is an expense for which no cash goes out that year.
Put what you learned to use right away
Financial Statements Lesson 15 · Why net income differs from operating profit→Financial Statements Lesson 7 · Assets: cash, inventory and the factory→This is educational material and not investment solicitation. There is no guarantee that past relationships will repeat in the future.