Net Income vs. Cash Flow
A statement of cash flows is an accounting tool used to accurately reflect actual money flowing into an organization. By itself, the income statement is an inadequate measure of cash flow because it contains several common non-cash flow items. A cash flow is usually money brought into the firm by its normal operations. Assuming that income represents a cash flow results in an inaccurate measure of a firm’s worth. This can lead investors to make suboptimal investment decisions.
Non-cash items on an income statement are not derived from a cash flow. A non-cash item is a change in income from a cash flow outside of the current reporting period. Often, Generally Accepted Accounting Principles (GAAP) allow for part of an expense to be realized in another time period than when the actual expense took place.
The most common non-cash item on an income statement is depreciation of an asset. Depreciation is the allocation of an expense over the life of an asset. For example, if a company buys a computer to help in its normal operations, the computer can not simply be expensed in the time period in which it was purchased. This is because a computer normally has a life of over one year and is therefore considered a long-term asset. The value of a long-term asset is depreciated over the course of its life, typically four to six years, and shows up on the income statement as incremental expenses. Note that the full price for the computer was paid for at the time of the purchase. However, the recognition of its decrease in value is computed over the life of the asset. To account for a greater decrease in value nearer the beginning of the asset’s life in comparison to the end, an accelerated depreciation schedule is often employed to more accurately account for the asset’s current value.
The accrual method of accounting states that income is recorded when it is earned, not necessarily when a cash flow has occurred as when a product is sold or a service rendered. For example, suppose that a company contracts with a department store chain to sell 1,000 boxes of its product. Often, the delivery of the product to the seller will occur before payment is made. In the accrual method, the cash flow that is owed the manufacturer shows up on the income statement as income even before the cash flow actually takes place. Consequently, the income statement can not be taken as a statement of cash flows.
A statement of cash flows is an accurate measure of the actual money a company received from normal operations. This statement in comparison to the income statement is invaluable to an investor when determining the profitability of a company. Unfortunately, the income statement is often taken to represent actual money flowing into an organization. Companies with huge investments in long-term assets have much more discrepancy between the income statement and the statement of cash flows because of massive amounts of depreciation. Also, companies who offer long-term payment plans often have large distortions as well because the accrual method allows for the recording of income before any money actually changes hands.