Relationship Between Net Income & Cash Flow

Knowing how to value a company is extremely beneficial, and can have very profitable outcomes. There is a lot of noise surrounding the stock market, with many books published, many accounting figures to understand, experts on television giving advice, and professors providing their investment tools. To become good at valuing companies, you have to be able to decipher between the noise and the important information. The relationship between net income and cash flow is one of those topics that leads to a lot of confusion.

Net income is how much the company profited during a time period in accounting terms. The generally accepted accounting principles (GAAP) have a set of rules and guidelines on how companies must report net income. Some of the revenue and expense accounts require a lot of estimates that require a lot of of guesswork by the accountants preparing the income statement, where the net income is found. Nevertheless, net income provides investors with a good idea of the earning power of the company and what kind of competitive position it is in.

On the other hand, cash flow requires no estimates by executives or anyone else. Cash flow is clear. If a company received cash, that is a cash inflow. If a company disbursed cash, that is a cash outflow. After all of the cash disbursements and cash receipts are added up, the resulting figure is the net change in the company's cash flow during that time period.

Sometimes there is a close relationship between net income and cash flow, and sometimes there isn't. A company can have big differences in cash flow and net income if the company receives cash before or after a sale is made. An example of that would be an insurance company. An insurance company receives premiums well in advance of when the insurance obligation is satisfied and revenues for insurance are recognized. There could also be big differences in cash flow and net income if a company reports non-cash gains and charges due to restructuring or other items. Differences also occur because of estimates a company has to make for accounts such as uncollectible accounts. Net income and cash flow have a close relationship for companies that collect cash when revenue is recognized. An example of that would be a retailer, which collects cash for goods when the sale is made.

Investors commonly value companies based on earnings. However, that is not necessarily the theoretical right way to value a company. The value of a company is the present value of its future cash flows. It is not the present value of its future earnings. Earnings do provide a good idea of how the company is doing and in combination with cash flow, it creates a powerful tool. However, just looking at earnings is a mistake, especially with companies that have huge differences in cash flow generation and reported net income. That could lead to a lot of incorrect valuations and big losses in an investor's portfolio.