There is a nice little saying from famous economist Alfred Rappaport that goes "profits are an opinion, cash is a fact." Comanies can do a lot of things to manipulate their profits on paper and make them look higher, but that's a lot harder to do with cash. One of the best ways to find out whether a company is manipulating earnings is look at the difference between earnings per share and free cash flow per share. If these two measures are far apart for an extended length of time, then as an investor, you should probably make sure you understand where the difference comes from.
The following is a chart showing Enron's earnings per share and free cash flow per share before it went bankrupt. As you can see, Enron was consistently profitable on an earnings basis but was deeply unprofitable on a free cash flow basis. Wall Street's highly paid MBAs were paying attention to reported earnings but not to cash flow. Enron also had other issues like hiding debt in off-balance sheet entities and highly polished execs with a great story to tell.
Source: "Online Investing Hacks" by Bonnie Biafore
The following is a chart of Worldcom's earnings and cash flow, which was another fraudulent operation which cost investors billions.
Source: "Online Investing Hacks" by Bonnie Biafore
Now let us look at a well-run, mature company like Intel (INTC, Financial). While income and free cash flow are not identical, they are consistent, and even if one is greater than the other in some years, they tend towards evening out.
The thing to understand is that the income sheet is usually scrutinized the most by investors, and this can be manipulated by dishonest management in dozens of ways. For instance, they can choose to record sales in one period but not collect money, or they can stuff inventory in trade channels (i.e. move product from the company's warehouses to customers' warehouses) and hide losses in working capital. Reserves, returns and bad debt may or may not be recorded in the right periods to collect bonus and incentives. Cash flow is more difficult to manipulate, and any manipulation will be spotted more easily by auditors and lenders who can match bank balances to reported cash and discrepancies spotted.
One of the most basic things an investor can do to mitigate risk is to keep an eye on both the income statement and the cash flow statement and be aware that they must be roughly consistent. If income is regularly positive but free cash flow is negative, that is a big red flag, and the company better have a good explanation. This is doubly true if the company is regularly seeking debt and equity capital in the market.
Of course, the above is mostly for non-financial companies, as financial companies are generally more balance-sheet focused. Because they make money on money, cash flows are much more complex and erratic. Most fraud in financial companies takes place at the balance sheet level. That is a topic for another day.
