Same net profit, two different quarters

Tuesday afternoon at the desk. Two Q4 results land in the same hour. Two midcap industrials. Both print Net Profit of Rs 245 cr. Both press releases say "record quarter". Both stocks open green the next day.

Then you open the cash flow page on each.

Company A collected Rs 220 cr of real bank deposits against that Rs 245 cr Net Profit. Cash conversion ratio 0.90. Working capital steady. Receivables in line with sales. Earnings showed up in the bank. Boring. Clean. The kind of quarter you can compound.

Company B collected Rs 38 cr against the same Rs 245 cr Net Profit. Cash conversion 0.16. Receivables blew out by 92 days. Inventory pile up across two warehouses. The profit is on the slide. The cash is on the customer's terms. Same income statement headline. Two completely different businesses.

Net Profit is what management chose to recognise. Cash From Operations is what arrived in the bank. The gap between them, what accountants call accruals, is the only line item that does not negotiate.

Sloan put a number on this in 1996. Sorted US listed companies into deciles by total accruals (Net Profit minus Cash From Operations). Bought the lowest decile. Shorted the highest. Earned roughly 10.4 percentage points per year of abnormal return through to 1991. Replicated globally inside the Quality Minus Junk factor framework (Asness Frazzini Pedersen 2019).

Three zones to file. Above 0.80 over three quarters is healthy. 0.50 to 0.80 is the watch shelf. Below 0.50 for three quarters running is a cliff, not a slowdown, because by the time the auditor flags it the multiple has already compressed twice.

Two reports. Same quarter. One is a paragraph. The other is the verdict

Where Rs 207 crore went missing

Cash conversion is one division. Cash from operations divided by net profit. For Company A, Rs 220 crore over Rs 245 crore is 0.90. For Company B, Rs 38 crore over Rs 245 crore is 0.16. The accruals are the difference: Rs 25 crore for A, Rs 207 crore for B.

The number tells you that something is wrong. The bridge tells you what. Every cash flow statement prepared the indirect way starts at profit and walks to cash, one line at a time. Here is Company B's walk for the quarter, with figures chosen to match the opening.

Start with net profit of Rs 245 crore. Add back depreciation of Rs 40 crore, because it is a cost on paper that did not leave the bank this quarter. That gives Rs 285 crore. Now the working capital lines. Trade receivables went up by Rs 190 crore: goods were shipped and booked as sales, but customers have not paid. Inventory went up by Rs 57 crore: cash was spent making goods that are sitting in the two warehouses. Rs 285 crore less Rs 190 crore less Rs 57 crore is Rs 38 crore. That is the cash from operations.

Company A's walk uses the same first two lines. Rs 285 crore, less Rs 40 crore of new receivables and Rs 25 crore of new inventory, is Rs 220 crore. A growing business always ties up some cash in working capital. The question is how much, and whether it keeps getting bigger.

Redo it with your own numbers

The three inputs you need are all on the cash flow statement of any listed company's annual report or half yearly filing on NSE or BSE. Profit, the non cash add backs, and the change in working capital.

A real cash flow statement has more lines than this: tax paid, changes in payables, provisions, interest. The simplification keeps the two lines that move most often in a bad quarter. If you want the full statement walked line by line, the free Learn module on revenue quality and earnings quality does it with a cash conversion calculator and a quiz.

Why one quarter is not enough

A single weak quarter can be honest. A big order shipped on 28 March will sit in receivables on 31 March and arrive as cash in April. That is why the zones in the opening use three quarters, or better, the full year.

Here is how the two companies might look across three quarters in a row. Company A at 0.92, 0.88 and 0.90: steady. Company B at 0.71, 0.44 and 0.16: each quarter worse than the last. The first figure is on the watch shelf. By the third, the trend is the story.

Two things make the gap worse in a growing midcap. Sales booked to distributors at the end of a quarter, which inflate receivables. And inventory built ahead of demand that may not come. Both show up on the balance sheet before they show up in profit. Which is why the post on earnings quality in five lines reads receivable days before it reads the headline, and the post on the working capital cycle shows how many days of cash a business really needs.