Question

Explain how cash balance and net income can diverge so significantly.

Answer 1

What is Cash Flow?

Cash flow is the blood of a business. It is the measure of what cash is coming in and what is leaving. Cash flow is a more accurate measure of whether a company has enough capital to sustain itself. For example, a company can be extremely profitable and still go out of business due to poor cash flow.

In planning a new business, cash flow is still a very important concept to focus on. Different services and habits affect cash flow. For example, a company’s payment terms greatly affect the amount of cash flowing in and out of a business. If it gives terms that are long, the business could have trouble meeting its other financial obligations. If the terms are short, it can give the business terrific cash flow.

The difference in length of terms comes down to the sizes of accounts receivable and inventory. If a business’s accounts receivable is high relative to its revenue, it is a sign of cash flow problems. Furthermore, if a company has a large inventory account, it can also be a sign of poor cash flow. A large inventory could show a purchasing problem that siphons cash faster than it is needed. Either way, if a business has too much tied up in inventory, it causes cash flow problems. The balance sheet and income statement might show a profit, but cash flow shows whether a business can sustain itself.

Cash Flow Statements

Cash flow statements are broken down into three areas. The areas are operating activities, investing activities, and financing activities. The idea behind separating these sources of cash is to get a better idea of where the cash is coming from. A detailed cash flow statement shows what amount came from loans, products/services, and investments. This can be very useful to investors and lenders.

What is Net Income?

Net income is calculated by subtracting total expenses from revenue. This is the ‘profit’ that most people refer to. Within the total expenses to be subtracted from revenue, overhead and cost of goods/services are both included. This means that net income is the measure of whether a company actually made money during a period. Due to accrual accounting, net profit does not automatically mean a business has cash. However, net income is efficient at tracking business done within a period. This makes net income a better estimate of profitability than cash flow.

Net income is the revenues recognized in a reporting period, less the expenses recognized in the same period. This amount is generally calculated using the accrual basis of accounting, under which expenses are recognized at the same time as the revenues to which they relate. This basis of accounting calls for the use of expense accruals to accelerate the recognition of expenses that have not yet been paid, as well as the use of prepaid expenses to defer the recognition of costs that have not yet been consumed. In addition, sales are recognized as they are earned, rather than when the associated amounts of cash payments from customers are received. The result is a net income figure that does not reflect the amount of cash actually consumed or generated in a period.

Net cash flow is the net change in the amount of cash that a business generates or loses during a reporting period, and is usually measured as of the end of the last day in a reporting period. Net cash flow is calculated by determining changes in ending cash balances from period to period, and is not impacted by the accrual basis of accounting.

Given these descriptions of net income and net cash flow, the key differences between net income and net cash flow are:

• Expense accruals. Expenses are included in the calculation of net income for which no cash payments may have yet been made.
• Prepaid expenses. Cash payments for costs incurred may be recorded as assets instead of expenses, since they have not yet been consumed.
• Deferred revenues. Revenues are excluded from the calculation of net income, because they have not yet been earned, even though the related cash may have already been received (perhaps as a customer deposit).
• Sales on credit. Revenues are included in the calculation of net income, because they have been earned, even though the related cash receipts may not yet have been received.