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Bottomline | Why you must look beyond profitsInvestors need to look beyond the P&L statement to get a true fix on the health of a business.By Sonal Sachdev   May 4, 2025, 5:10:09 PM IST (Updated)3 Min ReadWhen the Sage of Omaha, Warren Buffett, speaks, you listen. At the Berkshire Hathaway annual meet this year, Buffett said, “(It’s) something we’ve never really talked about publicly, but I actually spend more time looking at balance sheets than income statements. Wall Street often focuses on income statements, but I like to study balance sheets—ideally over an 8 to 10-year period—before I even glance at the income statement. You can’t hide as much on the balance sheet. It's harder to manipulate than earnings figures."

This is a very important message for all equity investors, especially in Indian mid and small caps where governance standards are not so high. It doesn’t take much to inflate revenues and profits for companies, but masking the reality is far more difficult in the balance sheet because high sales on credit and long working capital cycles can be easily spotted. What’s also important to look at is the cash flow statement.

Cash flow statements help track the flow of cash in a business. With cash being the lifeline for any business, how much cash is coming in, how it is being used and what is left at the end of the period are all important to track.

Cash flow vs book profit

Let’s say a company has reported strong growth in sales and book profits, but much of its sales are on credit and it takes 90 days or more to realise this money. Also, it gets only 45 days of credit from its suppliers. Such a company will need to raise/arrange cash to fund the shortfall for 45 days.

Now, if you have another company with similar revenue and profit growth, but it collects money from buyers in 45 days and pays creditors in 60 days. This company would tend to enjoy a cash surplus or float rather than having to borrow money. The latter would clearly be a far better business to invest in.

What’s more, very high credit sales and long working capital cycles also up the risk of some buyers not paying up at all or not before a long delay. This also ups the risk of business viability.

Cash and valuations

Given the importance of cash and cash flows, many seasoned investors prefer to value businesses on the basis of the cash they are expected to generate annually going forward. Investment guru and Oaktree Capital co-founder Howard Marks says, “Quantifying what something is worth is primarily based on its cash flow generating capabilities.”

While discounting future cash flows is the best method to adopt, this requires significant knowledge and experience of the business to be able to project the cash flows over a long period.

An easier fix is the cash flow yield for businesses that are expected to generate higher or similar cash flows in the future. This involves expressing of the annual cash flow as a percentage of the market value of the business. A high yield suggests an attractive valuation, while a low yield generally tends to imply that a stock is expensive.

Using cash flow yield

The cash flow yield at any point in time should be compared with the historical yield for the stock, the yield on peer stocks and the interest rate available on fixed-income investments.

Only if you have a favourable situation on the above counts should you consider looking to invest in a stock. Also, the yield alone cannot be the decider. You have to be convinced about the prospects of the business. The yield will only tell you whether a stock is relatively cheap or expensive

Happy investing!Continue Reading(Edited by : Ajay Vaishnav)First Published: May 4, 2025 5:09 PM ISTCheck out our in-depth Market Coverage, Business News & get real-time Stock Market Updates on CNBC-TV18. Also, Watch our channels CNBC-TV18, CNBC Awaaz and CNBC Bajar Live on-the-go!TagsbottomlineInvestingWarren buffett