Back in 2013, QBE Insurance Group Ltd (ASX: QBE) reported an after tax loss of US$244 million, or 22.8 cents per share (cps).

Yet that same year, QBE paid out a dividend of 32 cps.

Understanding why this can occur is actually pretty simple and will improve your skill as an investor.

How it works

The key is to appreciate the difference between a company’s reported earnings and the cash flow the company actually receives.

In 2013 QBE reported a huge US$1.2 billion write-down to the value of its assets. Under IFRS accounting rules this write down reduces reported earnings, even though it did not impact the cash flows the company took during that year.

The value of company assets dropped, but after expenses the cash that QBE actually produced from insurance premiums and investments was still available to fund a dividend, which the company directors elected to do.

I got to thinking about this while looking at the earning prospects for the much loathed FlexiGroup Limited (ASX: FXL), which likes to specifically focus on ‘cash’ earnings when reporting results.

Because of asset write-downs FlexiGroup intends to report a 35% drop to reported net profit after tax (NPAT) for the full 2016 financial year. However the company’s cash earnings (from cash flowing into the company) should actually rise by 8%. This in theory increases the cash available to fund the company’s dividend of 50%-60% of cash NPAT.

Why it’s so important to understand

One reason it’s so important to make the differentiation is so you can appreciate how easy it is for reported earnings to misrepresent the state of a business’s actual earnings engine and why great investors focus on ‘free cash flows’. It’s possible for a company to be earning truckloads of cash, but report falling earnings.

Reported earnings, in turn, drive earnings per share. So if reported earnings can misrepresent a business, we must be extremely cautious when considering the price-to-earnings ratio (which uses earnings per share) as a measure of value for a company.

For FlexiGroup it means that its price-to-earnings ratio will rise going forward when it reports its full year NPAT. However the economic engine driving the business will continue to churn out cash for investors and in my view shares currently look attractively priced.

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Motley Fool contributor Regan Pearson owns shares of FlexiGroup Limited and QBE Insurance Group Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.