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Understand the difference between cash flow and new income when running your small business

Cash Flow Vs Net Income: Keep These Things in Mind

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Cash flow and net income are two of the most critical financial metrics of small business accounting. They help determine how well a company is performing on paper and how well a company can meet its debt obligations.

Many small business owners confuse these and other terms, though, and don't understand the nuances of cash flow versus net income. It's essential that they do, though, as these terms are not just ones that live in the corporate finance world.

So, let's take a detailed look at what cash flow and net income are and their effects on a business.

What is cash flow?

You can look at cash flow in two different ways. The total cash flow of a company is its net working capital, plus its operating cash flow. The former is simply the difference between the company's current liabilities and its current assets.

The latter is a bit more complicated. It's a report of the cash outflows and cash inflows that come from ongoing operating activities. Cash flow from operations is the cash a company gets from revenue, and it excludes any non-cash items such as interest and investments.

All of this will appear on the statement of cash flows, one of the basic financial statements in business accounting. In general terms, this report will show the free cash flow of a company by showing the cash equivalents and actual cash that goes in and out of a company over a period of time.

The cash flow statement will show how well a company performs and manages its cash and the amount of cash on hand. In other words, it shows the success, or failure, of the company to generate enough cash to fund the operating expenses as well as pay any debt obligations.

Cash Flow Increase from Operating Activities

One thing that all companies would love to do is to increase cash flow from their operating activities. There are two main ways that a small business can integrate financial management and operations techniques to do this.

First, a company can improve its collection practices in accounts receivable. Reducing the number of days it takes to collect invoices will increase the amount of cash that flows into the company. The lower the number of days it takes for a company to collect on its receivables, the more cash is coming into the business in the short-term.

Second, a company can increase the days payable outstanding. If accounts payable can gain more days by which they need to pay their obligations, this can positively impact cash flow. That's because the company will have more cash on hand, as it doesn't need to flow out of the company as quickly as it did before.

What is net income?

Net income is another measure that will show a company's financial health over a given period of time. Net income will be included on the income statement, as will all expenses and revenues for the company. 

There is a simple formula used to calculate net income. It is:

Net income = Revenues earned from products or services - Expenses incurred to earn those revenues

Included in that cost of goods sold are depreciation, amortization, interest, taxes, and operational expenses. All get deducted from the company's revenues.

Net income is a profitability measure and is sometimes called accounting profit. It is not, however, the same as the company's net profit and cash flow.

In late October, Apple announced that its net income for the fourth quarter of its fiscal 2020 year, which ended September 26, was $12.673 billion. Here are the details of the calculation:

•    Total net sales: $64.698 billion

•    Other net income: $126 million

•    Total cost of sales: $40.009 billion

•    Total operating expenses: $9.914 billion

•    Provision for income taxes: 2.228 billion

The calculation then is:

(64.698 + .126) - (40.009 + 9.914 + 2.228) = 12.673

This same calculation of financing activities can be done for any company over any given time period to produce a net income number. Other examples can be found on any company's balance sheets and found online for any publicly-traded company.

What Is the Difference Between cash flow and net income?

While net income and cash flow both have to do with financial activities, there is one main differentiating factor: time.

In most cases, there is a delay in time between when companies document sales and when customers pay. If customers who receive an invoice pay in cash during the following accounting period, the company's cash flow will be okay. It will then have a good shot at maintaining positive cash flow.

However, suppose there is a more considerable difference between when the company first documents the sale and when the money is collected. In that case, there is a possibility for negative cash flows. 

The bottom line is that a company can show positive operating income but have negative cash flow.

From an accounting standpoint, net income is the first financial item that will appear on a company's cash flow statement. It is taken directly from the income statement.

Then, the company will calculate net cash flow in this next step. You add a company's net income, any adjustments with non-cash expenses, and any working capital changes.

Some of these non-cash expenses will be reflected in the net income but not the cash flow. That's because things such as depreciation expense, share-based compensation, and amortization will not affect the cash a company can generate over a period of time. Because of this, they must be re-entered into the cash flow statement when doing accrual accounting.

Income vs. Cash from Sales

Most companies will record revenue when they earn it and not when the money is received. In this case, the company's net income will increase right away.

However, the cash flow won't increase until the company collects on the outstanding invoice. If that collection happens simultaneously, the sale is made (such as at a retail store), then both income and cash flow will increase simultaneously. 

Many companies in the B2B world operate on net terms for their invoices. Income almost always increases when the company makes a sale. Cash flow, meanwhile, won't be impacted for 30 days or so, depending on the payment terms.

Income vs. Cash for Expenses

Expenses work in a relatively similar fashion. Companies may pay some of their expenses with cash. When they do so, the income statement will be adjusted immediately, showing a deduction.

Other assets have payment terms. This practice is done mainly for longer-term items such as equipment and real estate. In these cases, they get expensed over a more extended period of time. It's also known as depreciation. 

The cash that pays for these items will immediately affect the company's cash flow, but not its income. The income won't be affected until the company works depreciation into the equation at a later time.

Another example of this is inventory. Extra inventory that is sitting in a warehouse will affect a business' cash flow, as it needed money to purchase or produce it. However, it won't have any effect on income until the company sells the inventory.

Maintaining Cash Flow

Maintaining cash flow is one of the most important things a small business can do to ensure its success over time. Sales are excellent, but only cash can keep the business running. That's why it's crucial to stay on top of cash flow and keep it at healthy levels.

There are a few things that a small business can do to maintain cash flow. One way is to create policies for payments that increase your cash flow.

Payment terms are standard, but asking for a percentage of an invoice upfront is never a bad idea. You can also include incentives for customers to pay quicker, such as early payment discounts.

Small business owners will want to pay attention to their cash needs and typical cash flow levels at different periods. By doing a cash flow forecast, you can see times that might be good for investments and times when you may need to hold onto cash reserves.

Finally, make sure to keep on top of collections. Keeping aging at a reasonable level is one of the most effective ways of maintaining cash flow.

Should you manage your cash flow and net income reports yourself, or should you hire someone to do it for you?

Now that you understand the breakdown of cash flow versus net income, the obvious question becomes, should you manage these reports yourself or hire someone to do it for you? 

Small business owners are certainly smart enough to be able to run these reports when needed. They are savvy enough to bring on others to help them in areas where they don't have time or the specific skillset required.

But keeping these accounting tasks in-house, either by doing it yourself or hiring a traditional employee to do so, is not always the best idea. Today, you can get professional advice and help to manage, run, and maintain cash flow and net income reports from virtual bookkeepers.

Companies such as Punch Financial can provide you with an expert team of accountants who can handle the day-to-day management of your cash flow and net income reports. We not only help you manage the financial data but also give you insights into how you can improve your cash flow and boost your net income.

We also provide you with a dedicated CFO who can help you do forecasting and other expert-level services that would be next to impossible for you to afford to bring on in-house. Today, it just makes more sense for a small business to outsource their accounting needs to a virtual bookkeeper than to take time away from running their business.

Contact Punch Financial Today

Understanding cash flow versus net income is only the first step in getting a good handle on your company's finances. The next step is working with us to help manage and maintain these reports while providing tips and insights on how you can grow even more.

Contact Punch Financial today to find out all that we can do for you.

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