Cash Flow vs. Profit: Which Better Reflects a Company's True Health?

Introduction

In financial analysis, profit and cash flow are two key metrics for assessing a company's health. Profit, typically referring to net income (revenue minus costs and expenses), is commonly used to calculate valuation metrics like the Price-to-Earnings (P/E) ratio. However, Warren Buffett has repeatedly emphasized in his shareholder letters that cash flow often provides a truer picture of a company's operational health. This article analyzes the differences, advantages, disadvantages, and Buffett's perspective on both.

Differences Between Profit and Cash Flow

Profit: Calculated based on accrual accounting principles, it records accrued revenues and expenses rather than actual cash movements. For example, a company might record high revenue from credit sales before cash is received, while prepaid expenses or depreciation reduce profit without involving cash outflows. Profit can be manipulated through accounting policies, tax strategies, or one-time items to embellish financial statements.
Cash Flow: Focuses on the actual inflow and outflow of cash, typically categorized into operating cash flow (OCF), investing cash flow, and financing cash flow. Operating Cash Flow (OCF) best reflects the cash-generating ability of core operations. Free Cash Flow (FCF) = OCF - Capital Expenditures, further indicating the "actual cash" available for dividends, buybacks, or reinvestment.

Profit reflects "book performance," while cash flow reflects "actual liquidity." As Buffett stated: "Accounting profit is only the starting point; cash flow is the end goal."

Why Cash Flow Better Reflects True Health?

Stronger Resistance to Manipulation: Profit can be "window-dressed" by accelerating revenue recognition or delaying expense recognition, but cash flow is difficult to fake. Cash is tangible – companies cannot conjure it up with "creative accounting." In his 1986 shareholder letter, Buffett noted many companies generated high profits through accounting tricks but ultimately failed due to cash shortages.
Sustainability Indicator: High profit does not equal high cash flow. A company might show substantial profit due to large accounts receivable, but if customers default, depleted cash flow can lead to bankruptcy. Conversely, strong cash flow indicates a company can self-sustain operations, investments, and shareholder returns. Buffett favors "cash cow" businesses like Coca-Cola precisely for their stable free cash flow.
Early Risk Detection: Cash flow can expose problems sooner. Negative operating cash flow might signal a liquidity crisis while profit remains positive. In his 1990 letter, Buffett stressed prioritizing the cash conversion ratio (OCF / Net Profit) when evaluating companies; a ratio significantly below 1 may indicate accounting issues.
Long-Term Value Creation: Buffett believes a company's intrinsic value stems from its ability to generate cash, not short-term profit fluctuations. He often uses the concept of "Owner Earnings," approximating free cash flow, to value Berkshire Hathaway's investments.

However, profit is not useless. It provides an overall profitability framework, especially for growth companies where initial investments may cause negative cash flow, but profit growth signals future potential. Ideally, both should converge; prolonged divergence warrants caution.

Buffett's Classic Views

In numerous shareholder letters, Buffett consistently emphasized the importance of cash flow:

1977 Letter: He criticized the limitations of accounting profit, advocating a focus on economic reality over reported figures.
2002 Letter: Buffett wrote: "Cash is to business as oxygen is to life. Profit is opinion." Meaning cash is essential for survival, while profit is subjective interpretation.
His investment decisions center on finding businesses generating substantial free cash flow, like Apple or American Express – companies with high profits and strong cash flow, demonstrating the power of an economic "moat."

Conclusion

Overall, cash flow provides a truer reflection of a company's health than profit because it directly impacts survival and growth, whereas profit is more susceptible to manipulation. Investors should follow Buffett's lead: prioritize analyzing the statement of cash flows and combine it with the income statement for a comprehensive assessment. In financial analysis, cash flow is not just a health indicator; it is the cornerstone of long-term company value. A company with consistently strong cash flow is more likely to weather economic cycles, even if its profits fluctuate.