Net Income vs Cash Flows
These are 2 crucial metrics
but despite having some overlap…
they can be entirely different
➡️ What is Net Income?
Net Income represents your total profitability…
down to the last penny
it is calculated by taking all income accounts on your P&L - all expense accounts on your P&L
The official formula is
Revenue → what amounts you are recording as income (ex: saas revenue, product income)
[-] COGS → The cost to carry out your revenue (ex: cost of hardware, hosting & servers)
[-] Operating Expenses → the cost to run your operations (ex: payroll, advertising & marketing)
[+] Other Income → income earned from source outside of your core business model (ex: interest income, points from credit cards)
[-] Other Expense → expenses incurred from sources outside of your core business model (ex: interest expense, depreciation)
*note that some of the example above may show in different sections for other business, as it all depends on what your core business model is
➡️ What are Cash Flows?
Cash flows are pretty much what they sound like
They represent the total cash movements in your bank account from one period to the next
The official formula is the sum of
Cash from Operating Activities → cash movements from your P&L activities, and movements in your current assets / liabilities (ex: prepaid expenses, accounts payable, accounts receivable)
[+] Cash from Investing Activities → cash movements from items the business invests in, mostly related to fixed & intangible assets (ex: machinery & equipment, office furniture, patents)
[+] Cash from Financing Activities → cash movements from items related to financing the business (ex: taking out a line of credit, raising equity, paying off debt)
➡️ OK, so how do they relate?
Well…your net income is the starting point for calculating your cash flows
If you had no movements in any of your balance sheet accounts…
Your net income would equal your cash flows
but it’s almost a given that you would have changes in your balance sheet accounts
➡️ So why would they differ?
Consider the following
example 1 → you charge customers net 30 (this affects your AR)
example 2 → you purchase raw materials that you have yet to convert to COGS (this affects your inventory)
example 3 → you purchase office furniture (this affects your fixed assets)
example 4 → you take out a $300k loan (this would affect your liabilities)
all of these examples would affect your balance sheet, and not your P&L…
hence causing a difference
That’s my take on Net Income vs Cash flows