One of the toughest rites of passage investors go through is learning how to navigate financial statements. In particular, understanding the difference between accounting income and cash flow is a crucial skill in knowing what’s happening with a particular business.
Understanding accounting income
In order to determine income using generally accepted accounting principles, you take the revenue that a company recognizes for a specific period and subtract the cost of the goods or services that went toward bringing in that revenue. Further expenses such as research and development, depreciation and amortization, overhead costs, taxes, and interest on debt then get subtracted. Finally, extraordinary items such as impairment charges and gains or losses on asset sales get taken into account. The end result is net income.
Notice, however, that some of these items don’t involve actual cash. For instance, a company can recognize revenue even if it hasn’t yet collected payment from the customer. Other items, such as depreciation, are entirely accounting-based numbers that don’t necessarily match up to any actual reduction in an asset’s value and have no cash impact at all.
Getting to cash flow
In order to determine operating cash flow, you therefore have to make multiple adjustments to GAAP net income. They include:
- Adding back noncash charges like depreciation, amortization, and certain impairment items.
- Adding stock-based compensation that isn’t paid in cash.
- Adjusting for changes in accounts receivable, accounts payable, deferred tax assets and liabilities, and inventory.
- Adjusting to reflect gains or losses on asset sales.
- Adding back deferred revenue.
Some investors prefer to look beyond operating cash flow to calculate free cash flow. To get this additional number, you can subtract out the money the company spent on capital expenditures over the period.
Often, cash flow and accounting income figures will be completely different. That doesn’t mean that one is right and the other is wrong. It simply reflects the fact that the way you calculate each number is much different, and both measures give valuable information you can use to analyze a company.
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