We penalise companies which have a low and/or falling level of operating cash flow relative to reported net profit. In general, operating cash flows should be higher than report profit as depreciation and amortisation are added back to net profit in the cash flow statement. Indeed, CFO/net profit was 1.5x for our global sample of 16,000 companies between 2010 and 2015. If CFO is significantly below net profit, it suggests the company is either becoming increasingly aggressive in profit recognition through a higher level of accruals or experiencing deterioration in terms of trade.
There is a relatively large divergence between in CFO/net profit by industry. Asset heavy industries, such as electricity utility, tend to have high levels of CFO relative to profit (at around 2-2.5x), as shown in Figure 89. This reflects depreciation of their large asset bases. Meanwhile, industries with lower levels of depreciable assets, such as trading companies, have lower levels of CFO relative to profit (1-1.3x).
Our accounting screen is set to trigger a red flag when CFO/net profit is in the lowest 20th percentile relative to GICS industry peers (i.e. it is very low), and/or when there is an abnormally large deterioration relative to the normal rate of change amongst industry peers over one and three years. This latter red flag is triggered when the deterioration in CFO/net profit is in the 20th percentile relative to the change experienced by industry peers between 2010 and 2015. For scoring purposes we reverse the percentile.