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SMEs And Net Income

I think it's safe to say when assessing a potential investment from a fundamental approach that most of us that using seeking alpha would look to a company's cash flow as an important if not the key gauge of its ability to generate profit. However, in many SMEs some management and surprisingly often the senior ones have a bad habit of looking at net income instead, and in the worst cases even use it as an investment metric. Notions such as this belongs firmly in the 1970's, along with disco and flammable suits. It can sometimes seem like this is the area of finance where accountants have thoroughly persuaded many SME managers into believing that net income is the same as profit. We could easily list a handful of reasons why net income does not equate to profit, but for now it's easier to just leave it to one side and say, in general the accruals and cost matching principal mean that net income is at its very best a proxy for profit. For the sake of keeping things moderately interesting, let's leave the issues of tax structuring aside, as important as they are, for another time.

Perhaps this is stating the obvious but, if a company is not making cash in the long run it's toast; financial history is littered with large companies that failed because of their lack of ability to generate cash. To continue as a going concern a company may survive for a while on net income but ultimately it needs cash. A key tool in understanding a company's investment potential is the understanding of how its operating cash flow is being made and not to get caught up in ratios and other metrics that focus on net income.

The accrual method permits management various options to record financial transactions; this can often leave a wide scope for earnings manipulation. It's only natural that if managers are remunerated based on a metric within their influence, they will be very tempted to record transactions in a way that enables them make a larger bonus. Hence when they are remunerated based on net income there is great incentive to overstate profit before tax. So just to help highlight some of the ways this can be done, here are some of the classic adjustments you might want to look out for:

• The depreciation method;

• Assumptions of the pension account;

• Assumptions of the exchange loss/gain;

• The reserves for bad debts;

• The methodologies and assumptions of inventory/investment valuations;

• The timing for the impairment of intangible assets

A good place to look to get the ball rolling is to check if a company's cash flow from operation is lower than its net income; this may mean that something is up with the cash conversation cycle, particularly so if this situation has gone on for some time. The cash cycle can give great insight into how well a business can convert inventory into cash, and how long cash gets locked up on the company's balance sheet for. This by no mean indicates cash from operation can't be manipulated, managers can still extend payables, reverse charges and employ many other tricks; but these are much harder to sustain in the long run than the low hanging fruit of net income manipulation. On a more conceptual note, for some complex organisations such as banks, diversified conglomerates and multinational corporations, the notion of net income can often have little meaning to non-accountants or those lacking the time or energy to read all of the various notes to the financial statements