Net Income Is Up but Cash Is Down: What to Check
Reconcile profit and cash through working capital, capital expenditure, and debt repayments. This case examines collectibility and the purpose of spending before treating a cash decline as financial distress.
Profit reflects the recognition of revenue and expenses, while the cash balance reflects actual inflows and outflows, so they can move in opposite directions. Start with the adjustments in operating cash flow, then add investing and financing activities to reconcile the decline in ending cash and identify its causes.
Find cash tied up in receivables and inventory
Credit sales may already be included in profit even though the money has not reached the bank account. Buying inventory in advance can tie up cash to the extent that purchases exceed the inventory sold during the period. Conversely, delaying payments to suppliers temporarily preserves cash. In your analysis, mark increases in trade receivables and inventory as cash reductions, and increases in trade payables as cash additions. Simple changes in period-end balances can include acquisitions and exchange-rate effects, so reconcile them with the working-capital adjustments in the actual cash flow statement.
Distinguish the cash balance from operating cash flow
A company can generate ample operating cash and still end with less cash after building a factory or repaying debt. Checking operating, investing, and financing cash flows separately, following the activity classifications in IAS 7, reveals this distinction. Treating all cash spent on capital expenditure as evidence of weaker operations can distort your assessment of the business. Equally, an increase in cash funded by new borrowing does not establish that operations have become healthier. Separately check the notes for deposits included in cash equivalents that are unavailable for use.
Follow through to the next collection date
The explanation that growth increased working capital can be tested by checking whether receivables are collected at the next payment due date. If customers fall further behind on payments or inventory repeatedly has to be sold at a discount, reduce expected cash inflows. This is why cumulative quarterly operating cash flow, receivables aging, and debt maturities should be considered alongside the cash balance on a single year-end date. When assessing a cash decline, calculate not only why cash fell but also how much committed spending the remaining balance can cover. Do not count loans that have not yet been secured as cash.
Worked example
Hypothetical example: Start with net income of KRW 12 billion, add depreciation of KRW 3 billion, subtract a KRW 8 billion increase in receivables and a KRW 5 billion increase in inventory, and add a KRW 2 billion increase in payables. Operating cash flow is KRW 4 billion, assuming no other adjustments. If the company spends KRW 7 billion on equipment and KRW 2 billion repaying debt, total cash falls by KRW 5 billion. Opening cash of KRW 10 billion becomes KRW 5 billion. Profit rose 20% from last year’s net income of KRW 10 billion, but cash halved. You cannot conclude that earnings quality deteriorated before checking receivables collection and the purpose of the investment.
What to check
- Do not confuse cash flow statement adjustments with simple balance-sheet changes.
- Reconcile the gap between net income and operating cash flow item by item.
- Show capital expenditure and debt repayments separately.
- Check payment due dates and actual collection records for the increase in receivables.
Sources and primary materials
This is educational material about research methods. For an actual company decision, verify the filings and primary sources for the relevant period.