Whilst the quote is probably a little harsh, it draws from the fact that there is some discretion as to how profit is determined, but it is very difficult (although not impossible) to manipulate cash. Another quote along the same vein is “Revenue is vanity, profit is sanity, but cash is king.”
Investors evaluating a stock should look carefully at cash flow as well as considering profit. Cash flow can be measured in a number of ways, but the two most important are operating cash flow and free cash flow (FCF).
Operating cash flow refers to the cash that is generated through the normal operations of the business. Free cash flow is operating cash flow minus capital expenditure. It is the cash left over after a business has paid all its expenses and made the necessary investments to ensure its future and growth. This left over cash can then be used to pay down debt, increase the bank balance or pay dividends to shareholders.
Accounting standards allow for some measure of interpretation when determining certain revenue and expense items. Without getting too technical, it is largely due to the notion of accrual accounting. Accrual accounting requires that revenue be recorded in the period it was earned, which is not necessarily the same as when the cash was received. Likewise expenses should be recorded in the period they were incurred rather than when the cash may have been paid.
How this plays out in practice varies considerably across different types of businesses. Consider for example Coles (ASX:COL). As a supermarket, cash is received at the point of sale, and so revenue and cash receipts are recognised at the same time. Contrast this with Shine Justice (ASX:SHJ). Shine are a law firm that manage compensation claims as well as class actions. They operate on a no win - no fee basis. In practice it can take a year or two from the time the work is performed until the cash is received and in some cases it will never be received. Nevertheless, revenue is still recognised at the time the work is performed, so the revenue amount is based on assumptions as to the likely win rate. There is a risk that those assumptions may turn out to be incorrect.
FCF is harder to manipulate than profits. Cash has to be reconciled…
