Two Minutes Reading for business analysis
When you read about a company’s “earnings,” it might sound like the ultimate measure of success. But here’s the truth: earnings can sometimes be dressed up by accounting tricks, timing differences, or even management optimism.
💡 That’s why smart investors learn to follow the cash.
Earnings vs. Cash Flow: What’s the Difference? 🧐
Let’s look at a real-world example: Enron. Back in the early 2000s, Enron reported impressive earnings, making it look like a highly profitable company. However, much of this profitability was due to aggressive accounting practices, particularly “mark-to-market” accounting, which allowed them to book potential future profits immediately. While their earnings looked great on paper, their actual cash flow was often negative or much lower than their reported profits. They were essentially creating profits from anticipated future income, not actual cash received from current operations. This huge disconnect between high reported earnings and poor cash flow was a major red flag that ultimately contributed to their downfall.
Another common scenario involves companies with large inventory. A retailer might report strong sales and therefore strong earnings, but if those sales are simply moving products into inventory that aren’t selling to final customers, the company isn’t collecting cash. Eventually, they might have to heavily discount that inventory, hurting future profits and cash flow
A more recent example is NVIDIA in its Q2 FY26 results. The company reported strong net income of $26.4 billion, up 59% year-over-year, with revenue reaching $46.7 billion (up 56%) and operating income at $28.4 billion (up 53%), driven largely by its Data Center segment at $41.1 billion. However, operating cash flow dropped sharply from a record $27.4 billion in Q1 FY26 to $15.4 billion in Q2, due to working capital changes like increases in receivables and inventories. This illustrates how net income can appear smooth and impressive, while cash flow reveals bumpier realities from operational factors. you can get more details, see
Why Earnings Can Mislead 🤔
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Accounting Adjustments: Companies can shift expenses or use one-time gains to make profits look higher.
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Non-cash Items: Things like depreciation or stock-based compensation don’t involve actual cash leaving the business but can still affect reported earnings.
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Management Spin: “Adjusted” or “pro forma” earnings often remove costs that management says are unusual—but those costs may happen again.
Why Cash Is Harder to Fake 💵
Cash flow tells you how much money is actually coming in and going out. Unlike earnings, it’s tougher to manipulate over time.
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Operating Cash Flow: Shows whether the core business is truly bringing in money.
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Free Cash Flow: This is what’s left after necessary investments. It’s the money available to pay dividends, buy back stock, or reduce debt.
Why This Matters to You 🚀
As Warren Buffett says, “Earnings can be manipulated; cash is real.” When you evaluate a business, don’t stop at the income statement. Check the cash flow statement to see if the profits are backed by actual dollars.
In the long run, companies that consistently generate strong free cash flow are the ones that reward shareholders.
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