Understanding Net Income vs. Cash Flow (and Why it Matters)

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When discussing the financial health of a business, people often use the terms “net income” and “cash flow” interchangeably. This is technically incorrect, as the two concepts are very different. While it is important to understand the distinction between them, it is also important to recognize that they both have an impact on the financial health of a business.

Net Income

Also known as “net profit” or “the bottom line,” net income is the amount of money that a company has left over after all expenses have been paid. It is calculated by subtracting all expenses, including cost of goods sold, taxes, and operating costs, from total revenues. Net income is the amount of money that a business must pay out to shareholders, reinvest in the business, or use to pay down debt.

Cash Flow

Cash flow, on the other hand, is the amount of money that a business has coming in and going out. It is calculated by taking the total amount of cash that a business has on hand at the beginning of a period and adding any new cash that came into the business (ex: sales), and then subtracting any cash that left the business (ex: expenses). Cash flow is an important indicator of the financial health of a business, as it shows how well the business is managing its money.

What’s the difference, and why should you care?

The main difference between net income and cash flow is that net income is a measure of profitability, while cash flow is a measure of liquidity. Net income measures the profitability of a business by looking at the net amount of money that is left after all expenses are paid. Cash flow, on the other hand, measures the ability of a business to generate and manage cash. Cash flow is important because it shows how well a business can pay its bills and reinvest.

Net income is a measure of the long-term performance of a business, while cash flow is a measure of the short-term performance.

  • Net income is a measure of the overall profitability of a business over time and is used to determine the value of a business.
  • Cash flow, on the other hand, is a measure of how well a business is managing its money in the short-term and is used to determine how much money a business needs to pay its bills and invest.

Both net income and cash flow are two metrics that are critically important in understanding the financial health of a business and managing a business’s finances.

Need help with defining these two key performance indicators? Check out our Numbers Coaching services and our KPI Toolkit.

Want More Cash Flow? Check your EBITDA

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The life blood of any business is its ability to generate solid cash flow. Without positive cash flow, a company will eventually go out of business. This TIP will focus on one of four key pillars that drive cash flow. In this case we will look at “Earnings Before Interest, Taxes, Depreciation, and Amortization,” or more commonly known by the moniker EBITDA.

Where do you find this metric? One of the financial statements that you can get from your accounting system is the profit and loss statement. The very last number of this statement is typically labeled “net income.” Net income is the profit you have left over after paying all your expenses. When we add back to net income the interest expense, depreciation expense, amortization expense, and income tax expense we get the number for EBITDA.

EBITDA formula:

Net income +

  • Interest expense
  • Depreciation expense
  • Amortization expense
  • Income tax expense

= EBITDA

EBITDA is important for two reasons:

  1. It is a general indicator of your company’s ability to generate cash flow from the operations of your business
  2. It is used as part of the formula for valuing a business. Often someone who wants to buy a business will value it based on a “multiple” of EBITDA. In other words, they are buying your company’s ability to produce cash flow now and into the future.

To generate positive cash flow, you need to have a positive EBITDA. Otherwise, you are generally finding yourself starting your cash flow conversation in the negative position and will likely need to borrow money or find investors to provide capital to keep the company going.

Start with a positive EBITDA number and you can be more confident with your company’s ability to generate positive cash flow. Do you know your EBITDA?

Let us know if we can help you with this important metric.