Join Jim Stice for an in-depth discussion in this video Net income is not the same as operating cash flow, part of Running a Profitable Business: Understanding Cash Flow.
- A common misconception is that net income and cash flow are the same thing. Let's work through a simple example to demonstrate that this is not, and should not, be true. Here's the example: The owners of Kamila Company would like to know how well the company performed during the most recent year. The following four transactions occurred: Transaction A: During the year, the company signed consulting contracts totaling 30 million dollars. Transaction B: During the year, the company completed work on consulting contracts with a total contract price of 20 million dollars.
Work on the remaining 10 million dollars in contracts, 40% completed. Transaction C: During the year, the company collected cash from its consulting contracts totaling 13 million dollars. And then transaction D: on January 1st, the company purchased specialized engineering computers and software for 15 million dollars cash. Because of rapid developments in technology, these computers' software are expected to be useful for only a total of three years. Now let's consider the following questions.
Question 1: How much cash did Kamila Company generate during the year? Question 2: What was Kamila Company's net income for the year? Finally, Question 3: How well did Kamila Company perform during the year? Let's first think about question 1: "How much cash did Kamila Company generate during the year?" The calculation of cash generated, or consumed in this case, is very straightforward. Let's look at the transactions one by one. Transaction A: We signed contracts and are very happy, but we didn't collect any cash.
Transaction B: We did some work, lots of work, but we haven't been paid in cash yet. And because we are consultants in this simple example, we didn't spend any cash, we just thought; so again, no cash flow. Transaction C: Now we've collected some cash, 13 million dollars. Transaction D: And here, we spent some cash, 15 million dollars, to buy computer hardware and software. The cash flow calculation is simple: We collected 13 million dollars and we spent 15 million dollars, so our net cash flow is negative 2 million dollars.
An important thing to recognize about this cash flow number, negative two million, is that this is an exact number. There are no estimates, no uncertainty; it's an exact number. But is this a good measure of our economic performance for the year? No. We can get a better measure by using some judgment to evaluate what happened during the year. So let's look at question number 2: "What was Kamila Company's net income for the year?" Net income is designed to be a measure of economic performance. Net income is computed as revenue - expense.
Revenue is defined as the economic value created for the customers. Expense is defined as the economic value consumed by the company. So net income, or revenue - expense, is the net amount of economic value created by the company in doing business. You might disagree with these definitions of revenue and expense. You might have your own preferred definitions. Well, it's too late; "revenue," and "expense" are words owned by accountants. We, the accountants, get to define them. And this is how we do it. So let's go back over each of the four transactions and consider whether there is any economic value created for customers, revenue, or economic value consumed by the company, expense.
So, Transaction A: We've signed contracts and are very happy, but we have not yet created any value for our customers, so no revenue. Transaction B: We created lots of economic value for our customers. First of all, we are finished with 20 million dollars in contracts. That's economic value created for customers. In addition, we have completed another 40%, or four million dollars' worth, of the remaining ten million dollars in contracts. Our best estimate is that we have delivered value to our customers totaling 24 million dollars. Which is the 20 million dollars in completed contracts; plus four million dollars, the 40% of the remaining 10 million dollars in contracts.
That's our revenue. Transaction C: Yes, we collected some cash, thirteen million dollars, but we didn't create any value for our customers. All we did is take their cash. So, no revenue. Here you can see the essential difference between cash flow and net income. Cash flow versus economic value created. Transaction D: We spent 15 million dollars to buy computer hardware and software. But did we completely consume them this year? No. Our estimate is that these items will last for three years.
So this year we only consumed 1/3 of their value, or five million dollars. That's the 15 million dollar cost, divided by three years. Net income in this example is 19 million dollars, which is the 24 million dollars in revenue, the value created for our customers, and five million dollars in expense, the value consumed by the company. Here's the key question: Which measure gives a better reflection of the company's economic performance, the precise cash flow number of negative two million dollars, or the 19 million dollar net income number, which contains a couple of estimates? Cash flow information is precise and useful, but raw, unadjusted cash flow data are not a good measure of economic performance.
As illustrated by this simple example, revenue and expense measures are refined measures of economic performance. They produce the best measure of overall economic performance, which is net income. Question number three: "How well "did Kamila Company perform during the year?" Accountants must make estimates and assumptions, in order to convert the raw cash flow data into a more meaningful measure of performance: that's net income. This process is called "accrual accounting." But let's ask another question: How will Kamila pay its employees this coming Friday? You can't pay employees with net income.
This 19 million dollar net income number is a great measure of economic performance, but you can't deposit it in your employees' bank accounts. Employees must be paid with cash. Suppliers eventually need to be paid with cash. Income taxes must be paid with cash. And in terms of cash flow, Kamila consumed cash this year. If she wants to pay her bills, she needs to arrange some kind of financing: a loan from a bank, or more cash investment from the owners. Net income and cash flow are not the same thing.
Both measures give information about a different aspect of a company's business. And we need them both.
Want to hear more from Jim and Kay? Learn about all three types of accounting—financial, managerial, and income tax—in their Accounting Fundamentals course.
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- Differentiating between net income and operating cash flow
- Categorizing cash flow
- Using financial data to deduce cash flow
- Managing operating, investing, and financing cash flows
- Typical cash flow patterns
- Converting net income into operating cash flow
- Improving operating cash flow