The number on the income statement that can be faked (and the one that can't)
Assalamu alaikum,
Last week I asked what gaps you’re still working through in your investing journey. The replies were genuinely useful — thank you. I’ll be working through several of them in future editions.
One theme came up more than once: understanding financial statements. Specifically, knowing which numbers to trust.
Today I want to answer that directly. Because there is a number on a company’s financial statements that is surprisingly easy to manipulate — and a different number that is much, much harder to fake.
Most investors look at the wrong one first.
The Problem With Net Profit
Net profit — sometimes called net income or the “bottom line” — is the number most investors look at when they want to know if a company is making money.
It’s on the face of the income statement. It’s widely reported in financial news. It’s used in almost every valuation ratio you’ve ever heard of (P/E ratio, for instance, uses earnings — which is essentially net profit — as its denominator).
And it’s deeply unreliable.
Not because companies lie — though some do. But because accounting rules give companies legitimate choices about how to recognise revenue, when to record expenses, and how to treat certain costs. Different choices produce different net profit numbers, even for the same underlying economic reality.
Here are three legal ways net profit can look better than the business actually is:
Revenue recognition timing. A company can recognise revenue when a contract is signed rather than when payment is received or the service is delivered. This inflates reported revenue and profit in the current period — even if the cash hasn’t arrived yet and may never arrive in full.
Depreciation choices. When a company buys a long-lived asset — machinery, property, equipment — it doesn’t expense the full cost immediately. It depreciates it over time. The depreciation method and the assumed useful life are both judgement calls. A company can choose methods that defer expense recognition, boosting current profit.
Capitalising vs expensing costs. When a company spends money on something, it can either expense it immediately (reducing profit now) or capitalise it as an asset and depreciate it over time (spreading the impact). The decision of which costs to capitalise is a management judgement — and one that meaningfully affects the reported profit number.
None of these involve fraud. They’re all within the rules. But they mean two companies with identical underlying economics can report very different net profits.
What Free Cash Flow Actually Measures
Free cash flow is different. Fundamentally different.
Here’s the definition:
Free cash flow = Operating cash flow − Capital expenditures
Operating cash flow is found on the cash flow statement, not the income statement. It measures the actual cash the business generated from its operations — after paying suppliers, employees, taxes, and interest, but before investing in new assets.
Capital expenditures (capex) is the cash the company spent on maintaining and growing its physical assets — equipment, property, technology infrastructure.
Free cash flow is what’s left after both. It’s the real money the business has generated that could, in theory, be returned to shareholders, paid as dividends, used to pay down debt, or reinvested.
Why is it harder to fake?
Because cash is cash. You either have it or you don’t.
The accounting choices that affect net profit — revenue recognition timing, depreciation methods, capitalisation decisions — mostly don’t affect the cash flow statement. When cash actually changes hands, it shows up in operating cash flow regardless of how the income statement treats it.
A company that’s recognising revenue early will show high net profit but eventually see that difference show up as rising accounts receivable — money owed but not yet received. That receivable is an asset on the balance sheet, not cash in the bank. The cash flow statement will reflect the gap.
The Warning Signal: Profit Without Cash
The pattern you want to watch for is this:
High or growing net profit + weak or declining free cash flow.
This divergence is one of the most reliable early warning signals in investing. When a company consistently reports strong profits but generates little or no free cash flow, one of a few things is usually true:
- The business requires constant heavy investment just to maintain its operations (high capex relative to revenue — often seen in capital-intensive industries)
- Revenue is being recognised before cash is actually collected (rising accounts receivable — the income statement reports the sale, but the cash hasn’t arrived)
- The company is making accounting choices that flatter net profit at the expense of a clear picture of economic reality
- A combination of all three
None of these make the company uninvestable automatically. A capital-intensive business with strong free cash flow per unit of revenue can still be excellent. But the divergence is worth understanding — and worth examining closely before you commit capital.
How I Use This in Practice
When I open a company’s annual report (we covered this in Edition #2), I look at the income statement and the cash flow statement together. Here’s specifically what I check:
Step 1: Find net profit on the income statement. The bottom line. How much did the company report as profit?
Step 2: Find operating cash flow on the cash flow statement. The “net cash from operating activities” line. How much cash did the business actually generate from operations?
Step 3: Find capital expenditures on the cash flow statement. Usually listed under “investing activities” as “purchases of property, plant and equipment” or similar.
Step 4: Calculate free cash flow. Operating cash flow minus capex.
Step 5: Compare free cash flow to net profit. If free cash flow is consistently close to or above net profit over several years — the profit is real. If free cash flow is consistently and significantly below net profit — dig into why.
For a rough benchmark: over a 5-year period, I want to see cumulative free cash flow within 20–30% of cumulative net profit. A persistent gap larger than that warrants explanation.
A Halal Investor Note
This matters for Muslim investors for an additional reason.
One of the tests in the AAOIFI halal screen is receivables as a percentage of total assets. A company with bloated receivables — where revenue is consistently recognised before cash is received — will tend to fail this test over time.
The connection between strong net profit, weak free cash flow, and rising receivables is not coincidental. They’re all symptoms of the same underlying pattern: a business that looks better on paper than it actually is.
Running the cash flow check alongside the halal screen gives you a cleaner picture of whether a business is genuinely healthy — or just well-presented.
This Week’s Action
Pull up the most recent annual report for any company you’re currently watching or holding.
Find the cash flow statement (it’s usually the third financial statement, after the income statement and balance sheet).
Look for “net cash from operating activities” and “purchases of property, plant and equipment.”
Calculate the free cash flow. Compare it to the net profit on the income statement.
Are they close? Is one consistently much lower than the other? Do you know why?
You don’t need to do anything with the answer this week. Just observe. Over time, checking this number routinely will give you a feel for what a healthy cash conversion ratio looks like — and a sharp instinct for when something doesn’t add up.
Hit reply if you find something interesting. I mean it.
Wa alaikum assalaam,
Rizal Founder, Barakah Profits Former proprietary trader | Ex-KPMG | Ex-Standard Chartered
P.S. The Halal Stock Scorecard includes a check on free cash flow as part of the Business Quality assessment (Point 2). If you haven’t downloaded it yet, it’s at barakahprofits.com/scorecard. All the concepts we’ve covered in this newsletter are woven into those 21 checks.
