Cash conversion and earnings quality

"Earnings quality" describes how reliably a company's reported profits convert into actual cash. A company with high earnings quality reports ₹100 of profit and generates close to ₹100 of cash. A company with low earnings quality reports ₹100 of profit and brings in much less - or even none.

The two ratios that capture it

1. CFO / PAT - Operating cash flow divided by net profit. The standard cash conversion ratio.

CFO / PAT > 1.0 (5-year average)  → high quality
CFO / PAT = 0.7 to 1.0            → acceptable
CFO / PAT < 0.7 sustained         → low quality, investigate

2. FCF / PAT - A tougher test that also accounts for capex.

FCF / PAT > 0.6 (5-year average) → strong cash generation
FCF / PAT < 0.3 sustained        → company isn't really making cash

Always use multi-year averages, not single quarters. Working capital wobbles distort any one quarter's reading.

What drags CFO below PAT

• Receivables growing faster than revenue - customers paying slower
• Inventory build - products not selling through
• Provisions being released - non-cash benefits inflate PAT but don't add cash
• Deferred-tax benefits - accounting savings that haven't reduced actual cash tax
• Goodwill or other write-back items - bookkeeping movements that look like profit
• Forex gains on translation - unrealised, no cash