Financial Health: Reading Cash Flow and Debt
A company might show high earnings but be burning cash—because capital expenditure, debt repayment, or inventory build offset reported profits. Operating cash flow tells the truth: it's the money actually earned after paying suppliers and employees. Free cash flow (operating cash flow minus capital expenditure) is the money available for shareholders and debt service.
Watch for red flags: (1) Operating cash flow significantly below net income (suggests aggressive accounting). (2) Rising inventory and receivables that aren't justified by sales growth (suggests inventory stuck or customers not paying). (3) Negative free cash flow despite profitability (suggests unsustainable business model or heavy investment phase). (4) Rising debt levels without corresponding growth (suggests business isn't generating cash).
Debt matters more in some sectors than others. Banks and real estate inherently use leverage, and high debt is normal. Manufacturing and retail can often support debt if cash flow is stable. Tech startups often run at cash flow breakeven for years, which is acceptable if growth justifies future returns. The key is whether the company can service its debt from operating cash flow, and whether that cash flow is growing.
In India, watch for rupee devaluation risk if a company has significant foreign debt, and monitor interest coverage (EBIT divided by interest expense). A coverage ratio below 2 is risky; ratios above 5 suggest comfort. Compare debt levels and cash generation across peers to identify which are stronger. A company with lower debt and higher cash flow is better positioned to survive downturns, invest in opportunities, and return cash to shareholders.
- Operating cash flow is truer than earnings; watch for divergence.
- Free cash flow matters more than net income.
- Debt is fine if cash flow can service it; dangerous if it can't.
- Interest coverage and debt ratios differ by sector; benchmark against peers.