As an entrepreneur, there are plenty of metrics, numbers and ideas that you have to monitor, track, and keep an eye on both the day-to-day side. One of the most important aspects of managing a business is net income.
Income is one of the first metrics and data points that every entrepreneur learns about, either in business school or from work experience, and clearly occupies the majority of management time. There's a host of other areas that entrepreneurs, especially Millennial entrepreneurs, focus on when developing a business idea (like sustainability or customer service). All of these ideas require net income to bring them from concept to reality.
Income is clearly important and the calculation is relatively straightforward (revenues minus costs)--but there's another financial metric that is arguably more important for small businesses.
Cash flow is an idea that, if you think back to your Accounting 101 class, might seem to be a lot like net income, and this even applies to how cash flows are presented and analyzed. Both metrics apply to a certain period of time, have several different components, and measure certain inflows and outflows of funds through your business.
Even with these similarities, there is one particular fact that is critically important to keep in mind as you compare net income to cash flows as you manage and grow your business--they aren't the same. The specifics of cash flow analysis, measurement, and comparison between net income and cash flow are numerous enough to occupy an entire book (or class).
Don't worry, we won't go through all of them!
Let's take a look at a few of most important differences, facts, and items to keep in mind as you compare your net income and cash flow for your business. As always, be sure to work with your CPA or other financial professional familiar with both your business and financial goals before making any changes or strategic decisions.
1. Net income and cash flow are not the same.
One of the most common misconceptions that I see as a CPA working with entrepreneurs and small business owners is that people see net income and cash flow as the same thing. This couldn't be further from the truth.
For example, while accounts payable (bills you owe) and accounts receivable (payments you are due) play an important role in calculating net income and other financial statements, the changes in the accounts and items truly influence cash flow.
2. Bills cannot be paid with net income.
Net income, as you and I both know, is one of the most important financial metrics that you have to monitor, but you cannot pay bills with net income. Your suppliers, partners, other vendors, and employees need to be paid with actual cash flows.
You like getting paid in cash (actual currency), correct? Keeping an eye on the cash inflows and outflows of your business enables you to pay your bills, grow your business, and develop new business ideas.
3. You can figure out your cash flow starting with your income.
Net income and cash flow are different, but they are related, so let's take a quick look at an example of calculating your cash from your net income.
Your business starts off with reported income of $1,000, and the following information is available. Your accounts receivable increased by $200 during the month, and your accounts payable increased by $500 during this month.
So, taking a step back to analyze the performance of your firm on a cash flow basis you start with your net income of $1,000, subtract the increased in accounts receivable ,since you are owed this money but have not yet been paid. Then, you add the $500 increase to your accounts payable since, although you have incurred these services, you have not yet paid for them.
Long story short, your income for the period in question is $1,000, but your cash flow for the same period is $1,000 - $200 + $500, or $1,300.
Applying these differences across organizations of different sizes and you can quickly see just how important understanding the differences between net income and cash flow truly are. Cash flow truly represents the lifeblood of how business operates, pays its bills, and continues to grow it operations, so it's critically important for every entrepreneur to understand these differences.
It may sound complicated or abstract, but it is not all that complex, and gaining a better understanding of these concepts will help you manage your business more effectively.