Difference Between Cash Flow & Accounting Income

Investors reviewing a financial statement from a company will quickly notice that the company's reported income and its cash flow is not the same. Some companies might be making a very large amount of money in terms of their accounted income, but are doing rather poorly when it comes to cash flow. It's important to understand the difference between cash flow and accounting income to resolve confusion and avoid overvaluing or undervaluing an opportunity.

In accounting, net income is the sum total of all the company's revenues after expenses, depreciation and interest. It includes income from both cash and non-cash transactions. For example, the payment from a customer who purchases a product or service from the company on credit will add to that company's net income but may not add to its cash flow. Similarly, the company deducts losses to depreciation -- the decline in an asset's value over time -- from its net income, but does not lose cash in this transaction.

The cash flow statement is used to reconcile the difference between the company's reported net income and the actual amount of money that was received in cash. When computing the cash flow, the company adds back non-cash losses such as depreciation, capital losses, increases in debt and decreases in accounts receivable -- money owed to the company. Further, they must subtract out any gains that did not provide cash, including gains on capital assets, increases in receivables and decreases in debt. Cash may also come into the company from investments or capital financing activities, and these too must be accounted for on the cash flow statement.

The difference between net income and cash flow arises when a company opts to use accrual-basis accounting rather than cash basis. In cash-basis accounting, companies only record transactions when cash is actually spent or received; on accrual basis, transactions are reported when they're agreed to, even if no cash is exchanged. Accrual basis is generally more useful for getting an accurate picture of the company's financial condition, but the company's real cash flow cannot be ignored, because its ability to make good on debts or pay employees will be limited by the availability of actual cash.

The difference between cash flow and income is very important. In some situations, a company may need positive cash flow even more than it needs income -- companies may find themselves in bankruptcy even though they technically are profitable. This is why investors often consider both a company's income potential as expressed by its income statement alongside its ability to effectively manage its liquidity. A highly profitable investment with negative cash flow may be more risky than a significantly less-profitable opportunity that has a stable cash flow.