Key Takeaways
- 1Net income is an accounting measure; free cash flow is a cash measure
- 2Companies can report positive net income while burning cash (and vice versa)
- 3Free cash flow is harder to manipulate through accounting choices
- 4Persistently diverging FCF and net income is a red flag
- 5Our profitability factor uses cash-based measures to capture FCF quality
#Net Income: The Accounting View
Net income is the "bottom line" of the income statement — revenue minus all costs, taxes, and expenses.
Formula: Revenue - COGS - Operating Expenses - Interest - Taxes = Net Income
Strengths - Standard metric everyone reports - Used to calculate P/E ratio and EPS - Required by GAAP
Weaknesses - Includes non-cash items (depreciation, amortization, stock-based compensation) - Can be manipulated through revenue recognition timing - Accrual accounting allows earnings smoothing
#Free Cash Flow: The Cash View
Free cash flow measures actual cash generated after maintaining operations.
Formula: Operating Cash Flow - Capital Expenditures = Free Cash Flow
Strengths - Measures real cash, not accounting constructs - Harder to manipulate - Shows what is actually available to shareholders - Better predictor of dividend sustainability
Weaknesses - Capital expenditures can be lumpy (one big year, then low years) - Does not capture growth investments in working capital - Timing of cash receipts can distort
#When They Diverge: Red Flags
| Scenario | What It May Mean |
|---|---|
| Net income > FCF (persistently) | Possible earnings manipulation, aggressive accounting |
| FCF > Net income | High depreciation, conservative accounting (often positive) |
| Both positive and growing | Healthy business, high earnings quality |
| Net income positive, FCF negative | Investigate immediately — cash is not supporting reported earnings |
#Which Should You Use?
For Valuation - **P/E Ratio** (uses net income) — Good for comparing similar companies - **FCF Yield** (uses FCF) — Better for assessing actual return potential
For Quality Assessment - Free cash flow is superior for assessing business quality - Our profitability factor uses cash-based measures following Ball et al. (2016)
For Dividend Analysis - FCF is essential — dividends are paid from cash, not accounting earnings - A company with positive net income but negative FCF cannot sustain dividends
#The Bottom Line
When net income and free cash flow tell the same story, the company likely has high earnings quality. When they diverge, trust the cash flow.
Last updated: February 10, 2026