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%.
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.
