Cash Flow vs Net Income – What’s The Difference & Why Does It Matter?

Cash Flow vs Net Income – perhaps the most misunderstood financial and accounting terms. These two terms are often treated as if they’re the same thing. But they’re not. Here’s everything you need to know about Cash Flow and Net Income, and why they’re not the same thing.

Cash Flow vs Net Income – Why It’s Important To Know The Differences

Understanding financial statements can be extremely confusing, especially for beginning investors just trying to figure out where to start.

There are so many words used that, in everyday life, may mean close to the same thing but, when used in the world of finance or accounting, they mean only one thing and should never be confused.

In the context of cash flow vs net income, knowing the difference can mean knowing how to differentiate between:

• a profitable firm destined to go bust, vs
• a loss-making firm likely to thrive in the future.

Obtaining a good understanding of these differences is a very good idea for several other reasons that we’ll get into later.

But it has a lot to do with the media and how they advertise certain companies and their performance.

What is Cash Flow

Let’s start with defining cash flow, which is the amount of cash and cash equivalents that is moved in and out of a company over a specified period of time.

It’s a relatively simple concept because most people do budgets to have a solid understanding of their individual cash flows.

A corporate cash flow works almost the same way, such that broadly speaking:

• cash inflow represents cash flow coming into the business, and
• cash outflow represents cash flow going out of the business

The difference is that, where individuals should definitely be maintaining a positive cash flow at all times, businesses can sometimes be in a position where they are reporting negative cash flows.

This means their cash outflow is greater than their cash inflow.

Put differently, it means they have more cash flowing out than they have flowing in over a specified period.

Cash flows are an important metric for all businesses, private and public.

That’s because positive cash flows put the company in a position to:

• generate new business,
• expand existing projects, or
• generally take advantage of market conditions

Think of it like you would your own cash flows.

If you have a positive cash flow (where the inflow is greater than the outflow), you can invest excess money in retirement or other investments.

If your cash flow increases even more, you can either invest more or buy more expensive items on your wishlist.

Types of Cash Flows

There are a wide variety of cash flows, but we can broadly categorise them by ‘fields’ as:

• Cash flows from an Accounting perspective, and
• Cash flows from a Finance and Investing perspective

Let’s now consider both broad types.

Cash Flows from an Accounting Perspective

From an Accounting perspective, there are three main types of cash flow to understand:

• Cash Flows From Operations: also called Operating Cash Flow, this type of cash flow is the primary source of cash inflows as it is generated from sales of goods and services, and the operations of the business.
• Cash Flows From Investing: Just like you and me, companies invest funds for various reasons to generate returns and avoid holding actual cash wherever possible due to inflation. Cash flows from investments are reported like any other.
• Cash Flows From Financing: This type of cash flow comes from equity and debt financing activity in addition to the interest paid on loans held. When the company issues new debt, pays out dividends, or sells new shares, that is reported as financing cash flows.

You’ll find all these three cash flows in a company’s Cash Flow Statement (aka Statement of Cash Flows).

The sum of these three cash flows is equal to the Net Cash Flow, and it represents the net inflow of cash flow for a firm from all its activities.

Cash Flows from a Finance and Investing Perspective

From a Finance and Investing perspective, there are mainly two types of cash flow, including:

• Free Cash Flow (FCF): this is cash flow that’s freely available to distribute to both debt as well as equity investors of a company.
• Free Cash Flow to Equity (FCFE): also called “Flow to Equity”, this is the cash flow that’s freely available to distribute to equity investors of a company.

Both types of cash flow are used when valuing companies using the Discounted Cash Flow (DCF) valuation technique, for example.

And both types of cash flow are dependent on some combination of the cash flows highlighted above when we looked at things from an Accounting Perspective.

So, as an example, Free Cash Flow is calculated as…

   

Where:

• denotes Free Cash Flow
• reflects the Earnings Before Interest and Tax (aka Operating Profit)
• refers to the corporate tax rate
• reflects non cash expenses (e.g., depreciation, amortisation, etc)
• refers to the change in working capital, and
• denotes Capital Expenditure

Now, if we consider the first three components of the equation (i.e., ), then that is essentially identical to the Operating Cash Flow (aka Cash Flows from Operations) that we discussed earlier.

Yes, there can be minor differences, but in principle, it’s the same thing;.

How To Calculate Cash Flow

There are a few metrics to understand for a full picture of cash flow. And we’ve covered an example of Free Cash Flow (FCF) above.

But we don’t want to get too technical in this particular article.

Each type of cash flow naturally has its own calculation, but in essence…

It really boils down to starting with the cash received over a period of time and subtracting the cash paid during the same period.

Sure, there are ‘complications’ during the process, but in essence, that’s all it is.

What Is Net Income

Net income is the bottom-line number a company reports on its Profit and Loss Statement (aka Income Statement).

While there are several important figures in the P&L, the net income is the “earnings” that represents the core reason for reporting in the first place.

Note that Net Income is also called:

• Net Earnings
• Earnings After Tax
• Net Profit
• Profit
• Earnings

Net Income is used for several other important figures you may have heard of.

For instance, Earnings Per Share (EPS) is calculated by dividing the net income, or “earnings,” over that quarter by the number of shares outstanding.

This in turn also means Net Income is necessary to calculate the PE Ratio.

How To Calculate Net Income?

When calculating net income, the accountants start with the net revenue, which is all money received by the company after discounts and returns are considered.

After compiling the revenue, the accountants arrive at net income by subtracting all expenses the company had to pay out.

That includes employee wages, operating expenses, interest payments, taxes, depreciation, and really any payments that go out from the company, including non cash expenses.

We provide a much more detailed walkthrough on how to calculate net income here so do give that a read if you want to learn more.

Cash Flows vs Net Income – What’s the Difference?

There are several key differences between cash flow and net income.

First and foremost, despite popular belief, they are not the same.

They can be the same under very few, specific conditions (e.g., if a business uses “cash accounting” instead of “accrual accounting”).

But for the most part, businesses tend to use accrual accounting.

And this is why the primary differences in cash flows vs net income stem from when money is reported as earned.

While revenues might document sales having occurred during a particular period, the actual cash may not have been received by accounts receivable yet.

Put simply, a business may provide a service or make a sale today, but only get paid say, 6 months’ later.

Revenues and Net Income will reflect the service or product sold today, but the cash flows will not reflect this until 6 months’ later.

Differences in What’s Reported

Typically, growing companies like to report lower net income and maintain a higher cash flow.

Since cash flows can feed into a stable net income, growth is dependent on considerable cash flows which can then be used to pay for expansive projects.

In such instances, the cash flows would reflect large outflows as a result of paying for these new projects.

But Net Income may not reflect any of it explicitly because those types of cash outflows impact the Balance Sheet.

They aren’t reported on the Income Statement and therefore do not affect Net Income in any way whatsoever.

This is why some analysts will say that cash flow is the better metric of a company’s financial health.

Higher net income is great, but the ability to actually use that net income is dependent on receiving cash on the cash flow statements.

Once the cash is received, that money can then be used on new projects or expanding existing projects.

As an individual, it is very important to understand not only cash flow vs net income differences but also many of the other terms.

This is because the financial media often reports some terms but not others. This in turn can potentially drive financial decisions that aren’t backed by complete information.

Learning these terms is therefore extremely important and we trust you have a better appreciation for it now.

Alright, now that you know the main differences between cash flow vs net income, let’s consider some other questions you likely have in mind.

What Does It Mean When A Company Has Negative Cash Flow vs Net Income?

Tesla is a company famous for generating investor interest while, at the same time, reporting consistently negative earnings.

If you’ve ever been in the early part of the restaurant business, or any brand-new business really, you’ll know that the first few years are particularly difficult.

That’s because you’ve got heavy business debts to cover before you ever see a dollar of profit.

Debt payments represent one reason that a company might report negative cash flows.

And large debt interest payments can result in negative net income.

Even though it’s generating money, the company must focus on driving efficiency in the early years to keep the deficits as small as possible.

A company might also have negative cash flows for a given time period despite having positive net income.

This is largely because of:

• the gap between when money is reported as earned and when it is actually received in accounts receivable, and
• distortions that arise because of accruals principles / accrual accounting

A company with longer payment terms for their clients and shorter payment terms to their suppliers may create negative cash flow and positive net income reports.

In the context of negative Net Income, a company may simply have large losses owing to research and development efforts.

Importantly, this can depend on, and vary by the type of accounting standards used. Some standards don’t permit “expensing” R&D while others do.

The point is… a firm could have negative net income but be perfectly healthy from a financial standpoint.

And equally, a firm could have strong positive earnings but be in critical financial danger owing to large negative cash flows.

Is Negative Cash Flow Bad for a Business?

Debt burden is the reason Tesla reported negative cash flows for so many years.

Just because a company reports negative cash flows does not necessarily mean that it is in trouble.

While it might be difficult initially, a company may be able to obtain funding from outside sources to continue its growth.

This will hold as long as there is a strong belief that the end result will be profits.

When a company starts reporting negative cash flows after a long history of profits…

That might be a sign the company either:

• needs to drive better efficiency, or
• change the way it does business before investors start pulling out.

But it could also mean that the company’s investing massively for future growth.

As a general rule of thumb, negative cash flow is usually okay if it arises from investing activities.

Prolonged negative cash flows that arise from operating activities is simply not sustainable, however.

And that should act as stern warnings and strong alarm bells for you as an investor.

What’s Next: Cash Flow vs Net Income

It’s important to understand the differences between cash flow vs net income, especially if you watch financial news or invest in financial markets.

The media often tends to focus on one or two metrics when they talk about earnings. That’s likely because there are so many companies to talk about. And so little time while they have your attention.

As an individual, having a better understanding of these terms will allow you to notice when a news report may not have all the information you need to make an investment decision.

Learning as much as you can about financial terms by taking rigorous finance and investing courses can mean you not only make better investments but also avoid bad investments.