4.02 – Learning The Difference Between Cash Flow & Net Income
Cash Flow vs. Net Income
In most cases, cash flow from profit differs from net income due to variations in revenue and expenses. Cash collected from customers during a period is typically different from the sales revenue booked for the period, and cash paid out for operating costs often varies from the booked expenses. Understanding these differences is crucial for accurate financial analysis.
Financial reporting standards require more than a single line disclosure of cash flow from operating activities. Readers of financial statements need detailed information about the major factors causing cash flow to be higher or lower than net income. Smaller factors are often summarized under “other factors” or similar terms.
Key Factors Influencing Cash Flow
The following sections explain how changes in various assets and liabilities affect cash flow from operating activities. Managers, investors, and lenders should monitor these changes closely, as they can indicate the financial health and cash flow capabilities of the business.
Accounts Receivable Change
Synopsis: An increase in accounts receivable consumes cash flow; a decrease generates cash flow.
Accounts receivable represents the money owed by customers who bought on credit. If accounts receivable increases, it indicates that more sales were made on credit than were collected, reducing cash flow. Conversely, a decrease in accounts receivable means more cash was collected than sales made on credit, increasing cash flow.
For example, if a business starts the year with $6.718 million in accounts receivable and ends the year with $8.883 million, the increase represents a $2.165 million shortfall in cash inflow, affecting overall cash flow negatively.
Inventory Change
Synopsis: An increase in inventory consumes cash flow; a decrease generates cash flow.
Inventory is typically the largest short-term asset for businesses selling products. If inventory increases, it means the business spent more cash on inventory purchases than recorded in the cost of goods sold. Conversely, a decrease in inventory indicates that the business was able to turn inventory into cash without replacing it, positively affecting cash flow.
For instance, if a business reduces its inventory by $2.328 million due to shifting from product sales to software and services, this reduction generates cash flow.
Prepaid Expenses Change
Synopsis: An increase in prepaid expenses consumes cash flow; a decrease generates cash flow.
Prepaid expenses, such as insurance premiums or software subscriptions, are paid in advance and recorded as assets. An increase in prepaid expenses consumes cash flow, while a decrease generates cash flow.
For example, if prepaid expenses increase by $25,000, this amount negatively impacts cash flow for the period.
Depreciation: Real but Non-Cash Expense
Synopsis: Depreciation is a non-cash expense; it does not require a cash outlay.
Depreciation allocates the cost of long-term assets over their useful lives. While it decreases the book value of fixed assets, it does not affect cash flow. Sales prices should cover the cost of using these assets, contributing to cash inflow.
In the example, the business records $1.239 million in depreciation expense. The total recorded in the statement of cash flows is $1.739 million, including $500,000 in amortization expense for intangible assets.
Changes in Operating Liabilities
Synopsis: An increase in short-term operating liabilities generates cash flow; a decrease consumes cash flow.
Operating liabilities, such as accounts payable, accrued expenses, and income tax payable, are intertwined with expenses. If these liabilities increase, the business delays cash outlays, benefiting cash flow. Conversely, a decrease means the business paid more cash than the expenses recorded, negatively affecting cash flow.
For example, if accounts payable increases by $275,000, it indicates that cash outlay was $275,000 less than the expenses, positively impacting cash flow.
Putting the Cash Flow Pieces Together
Considering all adjustments to net income, a company’s cash balance from operating activities can show significant increases or decreases. For instance, a business might have a $7.593 million increase in cash flow due to factors like depreciation, amortization, and inventory reduction. The statement of cash flows reveals the detailed journey from net income to cash flow from operating activities, providing crucial insights into the business’s financial operations.
