Question 1

Why can a company be profitable on paper but still go bankrupt?

Accepted Answer

A company can appear profitable on an income statement while "bleeding out" because profit is often based on accounting opinions and non-cash adjustments rather than actual money in the bank. For example, a company might book revenue from sales where the customer hasn't actually paid yet (ballooning accounts receivable) or sell off long-term assets to create a one-time "record profit." If the company cannot collect enough physical cash to pay its immediate bills, it can fail despite what the "Net Income" line says.

Question 2

What is the difference between the Current Ratio and the Quick Ratio?

Accepted Answer

Both ratios measure liquidity, but the Quick Ratio—also known as the "acid-test"—is more conservative. The Current Ratio divides all current assets by current liabilities to see if a company can cover its short-term debts. The Quick Ratio takes this a step further by subtracting inventory from those assets before dividing. This asks the brutal question of whether a company can pay its bills without being forced to sell off its stock, which is vital because you cannot pay an electric bill or a creditor with unsold sneakers or car parts.

Question 3

What does "Free Cash Flow" tell an investor about a business?

Accepted Answer

Free Cash Flow (FCF) is considered the "North Star" for investors because it represents the actual cash a company has left over after paying for its operations and necessary capital expenditures, like new machinery or buildings. Unlike net income, FCF is a "fact" rather than an "opinion." A company with growing FCF has the "staying power" to pay dividends, buy back stock, or reinvest in growth without needing to constantly borrow money from banks.

Question 4

How can a company "fake" a high Return on Equity (ROE)?

Accepted Answer

While a high ROE is generally a sign of a healthy company, it can be artificially inflated through high financial leverage. Since ROE is calculated by dividing Net Income by Shareholders’ Equity, a company can take on massive amounts of debt to buy assets, which keeps the "Equity" portion of the equation very small. This makes even a modest profit look like a huge percentage return. To spot this, investors should compare ROE to Return on Assets (ROA), which measures how hard the company is working its assets regardless of where the money was borrowed.

Question 5

What are some common "red flags" to look for in financial reporting?

Accepted Answer

Key red flags include accounts receivable growing significantly faster than sales, which suggests the company is "stuffing the channel" or that customers aren't paying. Another warning sign is "capitalizing expenses," where a company treats a regular cost (like marketing) as a long-term asset to hide it from the current income statement. Additionally, investors should be wary of sudden changes in accounting methods, complex footnotes that seem designed to confuse, or management selling their own shares while publicly praising the company's performance.

Financial metrics and the truth about cash

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