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ACCA Strategic Professional · Advanced Performance Management · Financial performance measurement

Kestrel Co's board uses profit after tax as its main performance measure. Profit is $8m, but free cash flow has been negative for three years because of rapid credit sales growth and inventory build-up. Which is the most appropriate conclusion?

Profit may overstate sustainable performance because growth in receivables and inventory consumes cash. Persistent negative free cash flow signals liquidity and earnings quality concerns, so cash-based measures should be used alongside profit.

  1. AProfit may overstate sustainable performance and liquidity risk exists, so cash-based measures should supplement profitCorrect
  2. BNegative free cash flow proves that profit is understated and revenue recognition is too prudent
  3. CFree cash flow is irrelevant because profit already includes all revenues and expenses
  4. DWorking capital growth is a financing item and should be excluded from performance analysis

Explanation

Growth in receivables and inventory ties up cash, so accruals-based profit can be positive while cash is negative. This raises liquidity and quality-of-earnings concerns. Profit is not shown to be understated, and working capital is an operating item.

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