Quality of earnings

How closely reported profit tracks the cash the business actually generates, and how repeatable that profit is. High-quality earnings are cash-backed, produced by the core business, and likely to recur.

The simplest test is a ratio: operating cash flow divided by net profit, averaged over three to five years. The manufacturer at 1.28 is converting more than its reported profit into cash. A company running below 1.0 for several consecutive years is reporting profit it has not collected.

Beyond the ratio, four questions do most of the work. How much of pre-tax profit came from other income rather than operations. Whether receivables and inventory are growing faster than sales. Whether the tax paid in the cash flow statement resembles the tax charged in the income statement. And whether the same items keep being labelled exceptional.

None of these prove anything alone. Two of them together are worth a week of work.

Cash-backed, from the core, and repeatable.

A five-year table is the practical form of the test. Put net profit and operating cash flow side by side for five years, compute the ratio each year, and look at the pattern rather than the average. A company converting above one in every year is unambiguous. One that converts at 1.4, 0.6, 1.5, 0.5 and 1.4 is not smoothing anything; it is a business with a lumpy working capital cycle, and the average tells the truth. One that converted above one for three years and below it for the last two has changed, and the reason for the change is where the analysis goes next.