In: Accounting
Explain the difference between net income and net cash flow. Why are they different? Give an example from an actual company's financial statements.
Answer is as follows:-
Net Income is the revenues recognized in a reporting period and 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 relates. This basis of accounting calls for the use of expenses accruals to accelerate the recognition of expenses that have not yet been paid as well as the use of prepaid expenses to defer the record of the costs that have not yet been consumed. Additionally 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.
From the above given definations of net income and net cash flow the key differences between net income and net cash flow are as follows:-
1. Expense accruals. Expenses are included in the calculation of net income for which no cash payments may have yet been made.
2. Prepaid expenses. Cash payments for costs incurred may be recorded as assets instead of expenses, since they have not yet been consumed.
3. 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).
4. 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.
Example :-
A company has made revenue of $200 in 2017 and the expenses they have incurred was $110. That means, the net profit is $(200 – 110) = $90.
But if we look from the point of cash flow statement, we need to consider the cash inflow and cash outflow. The company’s cash inflow was $170 (as they have not collect the whole amount in 2017) and the cash outflow was $90 (the rest of the amount would be paid in 2018). So the net cash inflow is $(170 – 90) = $80.
So it has been proven that even if the company made a profit of $90, its net cash inflow was $80.