When Profits Can Be Deceiving: SEBI RA Highlights Importance Of This Simple Metric To Avoid Financial Traps

Relying solely on a company’s reported profits for investment decisions is a financial trap, warns SEBI-registered analyst Financial Sarthis.

The true quality of a company’s financial health is better determined by the CFO (Cash Flow from Operations) to EBITDA ratio, he said. The CFO/EBITDA is a metric that evaluates how effectively a company turns its earnings into real cash flow.

A company may look profitable on paper, but if it fails to convert those profits into cash, it could be a risky investment, he said.

For example, if a company reports an EBITDA of ₹100 but only ₹60 is cash flow from operations (CFO), then the CFO/EBITDA ratio is just 60%.

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Different business models also influence this ratio. A fast food chain typically collects cash instantly and shows a higher CFO/EBITDA, while payments to a construction company may come in stages, often resulting in a lower ratio, he added.

In some cases, the CFO can exceed EBITDA, such as with deferred revenue, where cash is received before services are delivered. However, very low CFO/EBITDA ratios could indicate early or fake revenue booking, rising receivables or inventory, poor working capital control, or even accounting manipulation.

Consider a defense company with a 5-year cumulative EBITDA of ₹6,073 crore and a CFO of ₹5,185 crore. It has an 85% conversion. Compare that to a consumer electronics firm with a cumulative EBITDA of ₹77 crore and a CFO of - ₹157 crore, then it is clearly a red flag.

A strong cumulative CFO/EBITDA ratio above 70% is generally a good signal. If it's below 70%, investors are advised to conduct further research before taking on new positions, the analyst said. 

It is crucial to analyze ratios over time, study multi-year trends, compare with peers, and assess the quality of earnings.

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