Business owners often have trouble interpreting how their business is performing. They see a net profit on their income statement but struggle with month-to-month expenses. Or they see positive cash flow and wonder why the income statement shows a loss.
Let’s answer the question, “What is cash flow vs income?” and take a closer look at these two key financial statements, how they are prepared, and what they mean.
What is Cash Flow?
Cash flow is cash moving in and out of a business. Inflows are cash coming into the business, such as revenue, money from the sale of assets, money from the sale of stock, a loan, or money received from the sale of inventory.
Outflows are cash going out of the business, such as purchasing inventory, paying workers, purchasing assets, or paying dividends to shareholders.
Cash flow is reported on a periodic basis on the Statement of Cash Flows.
Types Of Cash Flow
There are three types of cash flow:
Operating cash flow
Operating cash flow is money generated from normal business activities. This includes revenue from sales or services. It also includes depreciation of tangible assets, deferred income tax expenses, and changes in operating assets and liabilities.
Money spent on inventory, accounts payables, accounts receivables, and other current and non-current liabilities are also used to calculate operating cash flow.
Investing cash flow
Investing cash flow is money generated or spent through investment-related activities such as purchasing or selling property, plant, and equipment. Investment in securities also falls in this category.
Financing cash flow
Financing cash flow involves cash exchange between investors, owners, and creditors. It includes money raised from the sale of stock or dividends paid to investors.
The Cash Flow Statement
Prepared on a monthly, quarterly, or yearly basis, the Statement of Cash Flows is a calculation of each of these types of cash. It’s a detailed breakdown of what happened during a specific time period, and its summary is a good indicator of the health of a company.
The statement starts with net income and makes several adjustments related to cash generated as well as changes in operating assets and liabilities. Each of the types of cash flow results in a calculation that can be analyzed.
The most important number is the increase or decrease in cash and cash equivalents. A positive or negative cash flow is a very telling number.
A positive cash flow means that you earned more than you spent. This is typically a good thing, unless you fail to grow your business.
A negative cash flow is perceived as bad, but it depends on what is happening with the business.
Cash flow is often a matter of timing. If you have a massive influx of revenue one month and your bills are not paid until the next month, this will skew the numbers one way or another. Looking at a series of cash flow statements will bring to light patterns.
There are plenty of ways to even out cash flow so it’s more consistent. We’ll give you some suggestions on that in a minute.
What is Income?
Business income is earned from operations. Revenue minus the cost of doing business is reported as income. The IRS treats income differently depending on how your business is structured.
If you are a sole proprietor, your income is reported on an individual tax return and taxed as ordinary income. The business pays taxes as an entity if you are a corporation or an LLC with more than one member.
Types Of Income
Sales are the most basic type of income that a business generates. This includes selling products or services sold by cash or on credit. Here are several more types of income:
- Gross income is revenue minus the cost of goods sold, which only includes expenses paid for producing a product or service. It excludes fixed costs not directly related to operations, such as rent of a space or salaries of others involved in running the business.
- Net Income is calculated by taking sales minus the cost of goods sold, general expenses, operating expenses, depreciation, interest, taxes, and other expenses.
- Operating Income is total revenue minus cost of goods sold and operating expenses. This is money generated during the ordinary course of business. It does not include tax, interest payments, or income generated outside the scope of the core business.
- Other Income is a category on the income statement that includes income unrelated to operations. This might include rent on property that the business owns, assets sold, or interest on deposits or other investments.
- Exceptional Income is other income that is generated on a one-time basis. Examples include legal settlements, disposal of assets, restricting costs, or costs associated with discontinuing operations.
The Income Statement
The income statement, balance sheets, and statement of cash flows are the three statements companies use to report their financial performance.
Also known as the Profit & Loss Statement, the income statement focuses on revenue, expenses, gains, and losses.
Revenue includes those from operations as well as revenue from non-core business activities.
Gains are money made from the sale of long-term assets.
Expenses can be from primary activities, such as the cost of goods sold, depreciation, and money spent on research and development. Secondary activities include interest paid on loans. Losses are also included in expenses.
There are two types of income statements:
- Single Step is simpler to prepare but less detailed. Add your revenue and gains and subtract expenses and losses. This results in net income.
- Multi-Step provides a detailed breakdown of all four categories: revenue, gains, expenses, and losses. It’s easier to pinpoint areas where you are doing well and areas of concern. You can determine gross profits by taking net sales and subtracting the costs of goods sold.
Which Statement Should You Use?
A cash flow statement and an income statement present different information. To determine which one to use, you must determine what question you’d like answered.
If your goal is to show how much net profit or loss your company generated during the reporting period, use the income statement. It gives you an excellent bottom-line number to start with. Of course, you want to see a positive net income.
The cash flow statement provides more details and should be referenced if you are trying to determine how a company generates and spends its cash. This report will also show whether you have money to purchase equipment or take on more debt.
Income VS Cash From Sales
Just because a company is showing a profit, this does not correlate to a positive cash flow. It’s important to understand the difference between when money is earned and when it is received.
You have technically earned money if you sell a product or perform a service.
But if the client does not pay your invoice immediately, you do not have cash on hand. You have, however, earned income.
Your income statement will reflect this income, but your cash flow statement will not.
Cash flow depends on payment arrangements, so you can negotiate better payment terms to improve cash flow.
For example, instead of offering 30 days to pay or installments, you can ask for payment upfront or upon completion of the job.
Income VS Cash For Expenses
The same rules logic applies to the payment of expenses. Expenses can be paid in cash or over time. It’s important to think about how this will affect your reporting numbers.
If you pay cash for short-term assets, this money shows up immediately on the income statement. Long-term assets must be expensed over time through depreciation.
If you pay cash for a long-term asset, this will show up immediately on your cash flow statement but will not impact the income statement.
Same with the inventory. Your cash flow statement shows the expense immediately, but the income statement does not account for inventory until it is used in production.
Which One is More Important to a Business: Cash Flow or Income?
There’s no easy answer to this question. A business must look at all the reports and how they interact with one another.
One might assume that if a company is profitable, it has plenty of cash to pay its creditors, but this is not necessarily the case.
One might also assume that a company with positive cash flow is profitable, but you might be wrong.
Both reports tell a different story with different calculations. The best scenario is a profitable business with a positive cash flow, but you must dig into the details to discover the true story.
If a company shows a profit but can’t pay its bills, one has to determine the reason. Perhaps they have a lot of outstanding invoices from customers. Perhaps they just spent money on inventory or a piece of equipment.
Factors to consider include when invoices are being paid and how much investment is made into assets, inventory, and daily operations.
Frequently Asked Questions (FAQs)
What is the Difference Between Net Income and Cash Flow?
Net Income is revenue minus the cost of sales, operational expenses, depreciation, amortization, interest, and taxes. It’s a key number in determining profitability and the stock market relies heavily on this report to determine valuation.
Cash flow is money coming in and out of the business during normal operations. Cash flow starts with net income and makes adjustments for noncash transactions. Cash flow is the money a company has to work with.
What Are Some Early Signs Of Cash Flow Problems?
Cash flow problems result in the inability to pay expenses. Positive cash flow is sometimes a matter of timing. It affects operating decisions and can lead to the inability to grow the business or pursue opportunities.
Here are a few signs that your cash flow is in trouble:
- If your customers delay payment, this can alter your cash flow. Determine how much time it takes between when you complete your project and when you receive a check.
- The same principle applies when you pay creditors. If your supplier gives you 30 days to pay an invoice, schedule payment for the end of that period. The longer you can keep money in your account, the better your cash flow.
- If you spend more to provide a service or produce a product than you are charging, this will catch up to you.
- If your revenue numbers are stagnant or decreasing, and your expenses are rising, you might see tough times ahead.
Comparing numbers from month to month will show areas of concern.
How Can I Increase My Cash Flow?
Small changes can show significant increases in cash flow. Here are some ideas to get the ball rolling:
Change the terms of your payments from your clients and suppliers.
Shorten the time you give clients to pay and give them hard deadlines. Instead of saying net 30, provide a due date. Better yet, ask for a deposit before performing work or full payment upon completion of a job.
Make due dates near the beginning to the middle of the month to ensure they hit the current accounting cycle.
Follow up with those that fail to make payments or are consistently late. Negotiate better terms with your suppliers. Pay on the due date and not weeks before.
Keep up to date on your accounting records.
Use forecasting to ensure you sell enough to keep up with your invoices. Look at expenses to see where you can cut costs. Negotiate prices with insurance providers and suppliers.
Instead of paying premiums every six months, see if you can negotiate a monthly payment to spread the expense over time.
If sales are stagnant, investigate new products or upsell to your current clients.
Nurture prospects or determine new ways to market your products or services.
Instead of discounting services to get new clients, find ways to provide more value through packaging services.
Above all, make sure you are charging enough to make a profit on your product.
Before you are in financial trouble, apply for a business line of credit or overdraft protection.
Having the funds available doesn’t mean you need to use them, but it allows you to take advantage of opportunities. It also shows investors that you are wise with your money. But remember that too much debt and a maxed-out line of credit are negatives.
The Bottom Line
As a business owner, you need to prepare several financial statements.
Each of these provides valuable information about the health of your business, will help attract investors, and give you a breakdown of where you stand.
Comparing these reports over multiple time periods will show income and spending patterns and help you prepare for the future.
Paying attention to the numbers will eliminate surprises and allow you to make adjustments before running into huge problems.
Check our website for more helpful articles to help you keep what you make.
