A:

This situation may seem a bit counter-intuitive at first, but it is actually quite common and not too difficult to understand. Let's break down the factors at play to examine more closely how a company can have a negative net income and a positive cash flow.

When people talk about net income, they are talking about a number that has been computed by accountants and reported on the company's income statement. In simple terms, a company's annual net income is its revenue, minus all applicable expenses in a given year. If a firm's expenses are greater than its revenue, it will incur a loss for that year, which must be reported on its income statement.

Let's take a closer look at the different types of expenses a company can incur. A typical income statement will include expenses such as depreciation, the use of prepaid expenses, or losses recorded on paper for bad debt expenses. All of these expenses, while they do detract from a company's earnings (as reported by accountants) for the year, are not the kinds of expenses the company actually pays cash for. For example, consider the depreciation of a carmaker's factory and equipment: while this depreciation is indeed a legitimate expense for the company, it does not actually open its coffers and write a check to pay for this depreciation - it is a non-cash charge.

Now, let's say company XYZ had a net loss of $200,000 for the current year. Suppose the company recorded $200,000 in depreciation for the year, used up $100,000 of prepaid expenses (such as insurance premiums) and wrote off $150,000 of bad debts it knew it could never collect. The total value of XYZ's non-cash charges was $450,000, which means its actual cash flow for the year was $450,000 greater than its net income as reported on its income statement. Thus, it actually had a positive cash flow of $250,000 (-$200,000 + $450,000) for the year. Note that the company will not pay income tax for the current year, since it has recorded a net loss, but it actually has more cash on hand than it did at the start of the year. The fact that a company is not earning profits for its shareholders does not necessarily mean it does not have cash on hand to keep paying its bills.

Similarly, a corporation could have a positive net income but a negative cash flow for the year. Let's say a second company, PQR, posted a net profit of $150,000 for the year. However, the company is finding it difficult to pay its monthly bills since it has no cash on hand. How can this be? Suppose PQR bought a new, comprehensive multi-year insurance package in the middle of the year and paid $400,000 cash up front for it. Even though accounting rules only allow the company to claim a small portion of the insurance expense every year, it has paid $400,000 in cash today for many years of insurance coverage in the future. Thus, while the company's accountants must report corporate profits (which are taxable) of $150,000 for the year, the company actually has a negative cash flow for the year of $250,000 ($150,000 - $400,000). If this company is not careful, it may run out of cash to keep its business running smoothly, even though it is making a profit.

Before considering investing in a company's stock or bonds, investors should be aware of the strength of the company's net income and cash flow. After all, what good is it to a shareholder if a company has positive cash flow but repeatedly gets hit with net losses? At the same time, bondholders may find themselves losing their principal if a profitable company doesn't have enough cash on hand to service its debt.

(For further reading, see How Some Companies Abuse Cash Flow and Advanced Financial Statement Analysis.)

RELATED FAQS
  1. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  2. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  3. Do you discount working capital in net present value (NPV)?

    Net present value (NPV) calculations should include the discounted value of changes in working capital. This treatment of ... Read Full Answer >>
  4. How is working capital different from fixed capital?

    There are several key differences between working capital and fixed capital. Most importantly, these two forms of capital ... Read Full Answer >>
  5. How can working capital affect a company's finances?

    Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>
  6. What are working capital costs?

    Working capital costs (WCC) refer to the costs of maintaining daily operations at an organization. These costs take into ... Read Full Answer >>
Related Articles
  1. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  2. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  3. Investing Basics

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  4. Stock Analysis

    Understanding Chipotle's Financials (CMG)

    Learn about Chipotle Mexican Grill and its financial statements, including metrics such as comparable sales, operating margin and returns.
  5. Investing Basics

    How To Decode A Company’s Earnings Reports

    Earnings reports tell investors how a publicly-traded company is performing, but aren’t always easy to decipher.
  6. Economics

    The Basics Of Business Forecasting

    Whether business forecasts pertain to finances, growth, or raw materials, it’s important to remember that a forecast is little more than an informed guess.
  7. Investing Basics

    Analyzing A Bank's Financial Statement

    Investors should analyze a bank’s interest rate risk and credit risk when analyzing its financial statement.
  8. Investing Basics

    Analyze Cash Flow The Easy Way

    Cash flow statements reveal how a company spends its money and where that money comes from.
  9. Term

    What Are Quick Assets?

    A company’s quick assets can be easily converted into cash.
  10. Term

    Understanding Long-Term Investments

    Long-term investments are intended to be held for more than a year.
RELATED TERMS
  1. Short-Term Debt

    An account shown in the current liabilities portion of a company's ...
  2. Audit

    An unbiased examination and evaluation of the financial statements ...
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  4. Discounted Payback Period

    A capital budgeting procedure used to determine the profitability ...
  5. Selling, General & Administrative Expense - SG&A

    Reported on the income statement, it is the sum of all direct ...
  6. Current Liabilities

    A company's debts or obligations that are due within one year. ...
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center