Why does net income not typically equal cash from operations?

Cash flow before any investment or financing activities. If a company cannot generate adequate operating cash flow, it may need to rely on outside funding to meet its financial obligations.

Cash flow from operations is the cash version of net income. Net income figures include non cash costs such as depreciation and excludes other cash expenditures, such as purchases of plants or equipment.

Cash flow adjusts the income figures to a cash basis. Cash flow from operations is cash flow after adjusting for operating differences such as depreciation, but before adjusting for investments (such as purchases of plants or equipment) or financing. This information is taken directly from the cash-flow statement of the company's most-recent annual report.

Example: A media company posts net income of only $73 million. Its cash flow from operations, on the other hand, is $1.4 billion. (The reason: Big depreciation and amortization charges weigh down net income, but since they really aren't cash outlays, these changes have no effect on cash flow.) The company is a much healthier company than its net income would lead you to believe.

Many investors focus on cash flow from operations instead of net income because there's less room for management to manipulate, or accounting rules to distort, cash flow.

If net income is much larger than cash flow from operations, it's a signal that the company's earnings quality-the usefulness of earnings-is questionable.

If cash flow from operations exceeds net income, on the other hand, the company may be much healthier than its net income suggests. That's why many investors, when they try to value a stock, will use the price/cash-flow ratio the share price divided by cash flow from operations per share-instead of the P/E ratio.

Net income and free cash flow are related but are not the same measure. Net income represents a company's profit, whereas cash flow represents cash available to spend on growth or distributions. Learn more about their differences, definitions, and when to use net income vs. free cash flow.

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Cash Flow & Free Cash Flow Definitions

Put simply, cash flow represents money coming into and going out of a business, while free cash flow represents money left over after a business pays its financial obligations.

Definitions of cash flow and free cash flow are:

• Cash flow in a business refers to the amount of cash coming in and out of a company during a specific point in time. Positive cash flow means that more money is coming in than going out, while negative cash flow means the business is spending more than it's receiving.
• Free cash flow (FCF), is the amount of cash remaining after a business pays for its capital expenditures. In simple terms, FCF is cash that a business can use to invest in growth or pay dividends.

Net Income Definition

Net income is the net amount of revenue that a company earns after taking into account all expenses for the same period. Thus, to calculate net revenue, total expenses are subtracted from total revenue. Often referred to as "the bottom line," net income is reported by public companies on both quarterly and annual income statements.

Cash Flow vs. Net Income

Cash flow and net income share some similarities but they are different items with unique calculations and purposes. For example, the cash flow statement and the income statement are completely different financial statements.

Cash Flow:

• Refers to the net amount of cash generated by a company over a specific period of time.
• Calculated by subtracting total cash outflow from total cash inflow.
• Enables investors to review historic cash flows of a company and to make estimates for future cash flow, which can help to determine the present value of the stock.
• Predicting future cash flow requires making assumptions about future growth. Cash flow may also be more volatile than net income.

Net Income:

• Refers to earnings after taking into account all expenses for the same period.
• Calculated by subtracting total expenses from total revenue.
• Helps investors identify how much profit a company generated after paying all of its expenses.
• Can be misleading because a high net income doesn't always mean that a company is profitable. Cash flow analysis is sometimes a better metric for measuring the financial health of a business.

Free Cash Flow vs. Net Income

Free cash flow and net income are not the same. For example, analyzing free cash flow can help investors better value a company because it's less manipulative than net income.

Free Cash Flow:

• Must be manually calculated by finding cash flow from operating activities on a company's cash flow statement, then subtracting out capital expenditures.
• When positive, it indicates a company's potential for investing in growth or paying dividends to shareholders.
• Can be more effective than net income for measuring a company's financial health but relies heavily on assumptions that may prove to be incorrect.

Net Income:

• Can be easily found by looking at "the bottom line" of a company's income statement.
• When positive, it indicates that a company's revenue exceeds its expenses, meaning that it has earned a profit.

When to Use Net Income vs. Free Cash Flow

Net income is a good starting point for determining the profitability of a company but free cash flow is better for determining if a company is a good investment. This is because free cash flow goes further to show the amount of profit that a company has available for discretionary use, such as investing in growth, paying dividends, or building cash for future use.

Bottom Line

Net income and cash flow have similarities but they do not share the same meaning or purpose. For example, net income shows a company's profit but free cash flow can show an investor more about a company's potential for pursuing opportunities that may enhance shareholder value.

This article was written by

Kent Thune

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Kent Thune, CFP®, is a fiduciary investment advisor specializing in tactical asset allocation and portfolio management with a focus on ETFs and sector investing. Mr. Thune has 25 years of wealth management experience and has navigated clients through four bear markets and some of the most challenging economic environments in history. As a writer, Kent's articles have been seen on multiple investing and finance websites, including Seeking Alpha, Kiplinger, MarketWatch, The Motley Fool, Yahoo Finance, and The Balance. Mr. Thune's registered investment advisory firm is headquartered in Hilton Head Island, SC where he serves clients all around the United States. When not writing or advising clients, Kent spends time with his wife and two sons, plays guitar, or works on his philosophy book that he plans to publish later in 2022.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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