If you only remember one thing about reading a financial statement, make it this: Net income is an opinion. Cash flow is a fact.
It is a mantra worth repeating. Every major accounting scandal in history—from Enron to WorldCom—could have been spotted early by investors who understood the difference between the two.
We live in an era of "adjusted" profits and headlines screaming about earnings beats. But beneath the noise, there is often a quieter reality.
Companies can manufacture earnings. Accounting rules give management plenty of room for "judgment." They can pull revenue forward, push expenses back, and move costs around to make the bottom line look healthy. They aren’t necessarily breaking the law; they are just using the rules to their advantage.
But cash is different. Cash either hit the bank account, or it didn’t. You cannot fake a bank balance.
At Blank Capital Research, we believe the divergence between what a company says it earned and the cash it actually generated is the most important signal in markets. Here is how to read it.
The Great Disconnect
To understand why "profit" can be an illusion, you have to understand how businesses keep score.
In our personal lives, we live on a cash basis. If you have money in the bank, you can buy dinner. If you don’t, you can’t.
Businesses are different. They operate on an accrual basis. This means they record revenue when it is earned, not when the cash arrives. If a company signs a $10 million contract today but won't get paid for six months, they still book $10 million in revenue today. Their profit jumps. But their bank account hasn't budged.
Conversely, if that company buys a $50 million factory, they don’t count that entire cost against their profit today. They spread the cost out over 30 years. The profit number looks smooth, even though $50 million just walked out the door.
This timing mismatch is where the danger lies. It creates a gap where financial engineering thrives.
The Lie Detector
While the Income Statement involves estimates and opinions, the Cash Flow Statement acts as the lie detector. It reconciles the accounting profit with the cold, hard reality of the bank balance.
It’s divided into three buckets.
1. Operating Activities (The Engine)
This is the most critical section. It shows how much cash the business generates from its actual day-to-day existence—selling products, consulting, or delivering packages.
It takes the "Net Income" figure and reverses the accounting tricks. It adds back things that didn't actually cost cash (like the decline in value of old equipment) and adjusts for the bills that haven't been paid yet.
The rule of thumb: A healthy business generates positive cash from operations. Consistently. If a company reports a profit but is burning cash in its operations, something is wrong.
2. Investing Activities (The Future)
This tracks where the company is spending money for the long term. The big number here is Capital Expenditures, or "Capex." This is the cash cost of staying in business—replacing worn-out machines, fixing roofs, updating software.
3. Financing Activities (The Lifeline)
This tells you how the company funds itself. Are they borrowing money? Selling stock? Paying dividends?
A company that consistently relies on Financing (borrowing) to cover a hole in Operations (selling) is in trouble. They are paying yesterday’s bills with tomorrow’s loans.
Sidebar: The "Growth" Trap
To see how this works in practice, let’s look at a hypothetical market darling: Tech ABC Inc.
The Narrative: Tech ABC is disrupting logistics. Revenue is up 40%. They just reported their first profitable quarter, with $15 million in net income. Wall Street cheers.
The Reality: You flip to the Cash Flow Statement.Net Income: +$15 million.Operating Cash Flow: -$20 million.
How can they be profitable but burning cash? The statement reveals two things:
1. The "Check is in the Mail": Tech ABC booked sales, but customers haven't paid yet. Accounts Receivable is growing faster than revenue. This suggests they might be signing up customers with bad credit just to hit growth targets.
2. Moving Costs Around: Instead of counting developer salaries as an immediate expense, they labeled them "software development assets." This moves the cost off the income statement (boosting profit) and onto the balance sheet.
The Verdict: Tech ABC isn't profitable. It is bleeding cash and funding the optical illusion by issuing stock to employees. When the sentiment shifts, the stock likely goes to zero.
The Number That Actually Matters
Operating cash flow tells you what the business generates. But it doesn't tell you what you, the shareholder, actually get. For that, you need Free Cash Flow.
The formula is simple:
Free Cash Flow = Operating Cash Flow - Capital Expenditures
That’s it. Take the cash from selling your product, subtract the cash needed to keep the lights on and the machines running, and what’s left is yours.
This is the cash available to pay dividends, buy back stock, or pay down debt. It is the truest measure of economic performance—better than Net Income, and certainly better than EBITDA (a metric Charlie Munger famously critiqued).
A warning on "Growth Capex":
CEOs love to argue that you should ignore their spending because it's for "growth." Be skeptical. In a competitive market, spending money on new technology or factories is often just the price of survival. If Intel builds a new factory, is that growth? Or is it just the cost of not becoming irrelevant? We treat all capital spending as a real cost.
The Playbook: How to Spot the Fakes
If you want to spot a disaster before it happens, you need to watch for the specific ways companies widen the gap between reported earnings and actual cash.
1. The Revenue Illusion ("Channel Stuffing")
At the end of a quarter, a company might ship excess inventory to distributors that they didn't order, just to hit a revenue target.
- The tell: Revenue goes up, but cash doesn't. The "Accounts Receivable" line spikes.
2. The Liquidity Trick ("Stretching Payables")
The CFO tells the team, "Don't pay any vendors until next week."
- The tell: Cash looks artificially high for one quarter, but the "Accounts Payable" balance surges. You can’t delay bills forever.
3. The Warehouse Problem
A company keeps factories running at 100% to make the "per-unit" costs look lower, even though demand is falling.
- The tell: Inventory grows much faster than sales. They are trading cash for unsold goods that will eventually have to be written down.
What to Watch
You don't need a Bloomberg terminal to do this. You just need to check three things.
1. The 1:1 Rule
Over time, a company's Operating Cash Flow should be roughly equal to (or higher than) its Net Income. If a company consistently converts less than 80% of its profit into cash, be very suspicious.
2. The Trend
One bad quarter is noise. Three is a pattern. If earnings are rising steadily while cash flow stays flat, the business quality is deteriorating.
3. The Yield
Forget the P/E ratio. Look at the Free Cash Flow Yield (Free Cash Flow divided by Market Cap). This tells you the actual cash return on your investment. If a risky stock offers a lower cash yield than a safe government bond, walk away.
The Bottom Line
Investing is difficult because it requires predicting the future. But you can avoid many unforced errors just by understanding the present.
When a CEO touts a "record quarter," ignore the adjectives. Go straight to the Cash Flow Statement.
Ask yourself: Did the cash come in? Did they have to spend everything they made just to keep the doors open?
Over the long run, the stock price always follows the cash. Net income is an opinion. Cash flow is the fact.
For specific research applying these principles, subscribe to Blank Capital Research.
