Net Income Is NOT the Same as Operating Cash Flow

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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.

The owners of Kamila Company would like to know how well the company performed during the most recent year. The following four transactions occurred.

a.   During the year the company signed consulting contracts totaling $30,000,000.

b.   During the year the company completed work on consulting contracts with a total contract price of $20,000,000. Work on the remaining $10,000,000 in contracts is 40% completed.

c.   During the year the company collected cash from its consulting contracts totaling $13,000,000.

d.   On January 1, the company purchased specialized engineering computers and software for $15,000,000 cash. Because of rapid developments in technology, these computers and software are expected to be useful for only a total of three years.

Now let’s consider the following questions.

1.   How much CASH did Kamila Company generate during the year?

2.   What was Kamila Company’s net income for the year?

3.   How well did Kamila Company perform during the year?

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.

a.      We signed contracts, and are VERY happy, but we didn’t collect any cash.

b.      We did some work, lots of it. 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.

c.      NOW we collected some cash, $13,000,000.

d.      And here, we spent some cash, $15,000,000, to buy computer hardware and software.

The cash flow calculation is simple: We collected $13,000,000 and we spent $15,000,000, so our net cash flow is NEGATIVE $2,000,000.

An important thing to recognize about this cash flow number, NEGATIVE $2,000,000, is that this is an EXACT number. There are no estimates, no uncertainty.  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.

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 minus 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 minus EXPENSE, is the net amount of economic value created by the company in doing business.

Now, you might disagree with these definitions of Revenue and Expense. You might have your own preferred definition. Well, it is 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).

a.      We signed contracts, and are VERY happy, but we have not yet created any value for our customers. No revenue.

b.      We created LOTS of economic value for our customers. First of all, we are finished with $20,000,000 in contracts. In addition, we have completed another 40%, or $4,000,000 worth, of the remaining $10,000,000 in contracts. Our best estimate is that we have delivered value to our customers totaling $24,000,000 which is $20,000,000 plus $4,000,000 (the 40% of the remaining $10,000,000 in contracts).

c.      Yes, we collected some cash of $13,000,000, 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 vs. economic value.

d.      We spent $15,000,000 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 consumed only one-third of their value, or $5,000,000 ($15,000,000 cost divided by 3 years).

Net income in this example is $19,000,000 which is $24,000,000 in revenue (value created for customers) and $5,000,000 in expense (value consumed by the company).

Now, here is the key question: Which measure gives a better reflection of the company’s economic performance … the precise cash flow number of NEGATIVE $2,000,000 or the $19,000,000 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, net income.

3.   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 = net income. This 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 $19,000,000 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.