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 is the difference between operating cash flow and net income?

    Learn how net income is an income statement for a certain period of time, while cash flow shows inflows and outflows based ... Read Answer >>
  2. What is the difference between net income and cash flow from operating activities?

    Learn how net income differs from cash flow from operating activities and how noncash expenses and changes in working capital ... Read Answer >>
  3. What will examining a company's cash flow from operating activities tell an investor?

    Understand what examining a company's cash flow from operating activities tells an investor. Learn why the cash flow statement ... Read Answer >>
  4. What is the difference between a cash flow statement and an income statement?

    Learn how a cash flow statement measures the sources and uses of a company's cash, while an income statement measures a company's ... Read Answer >>
  5. What is the direct method of calculating cash flow from operating activities?

    Learn how a company prepares its cash flow from operating activities using the indirect method, and understand the difference ... Read Answer >>
  6. What are some examples of how cash flows can be manipulated or distorted?

    Read about some of the most common accounting techniques that can be used to manipulate the operating cash flow on a company's ... Read Answer >>
Related Articles
  1. Investing

    Calculating Net Cash

    A company’s net cash is its total cash remaining after it subtracts all liabilities.
  2. Investing

    Cash Flow From Investing

    Cash flow analysis is a critical process for both companies and investors. Find out what you need to know about it.
  3. Investing

    What Is A Cash Flow Statement?

    Learn how the CFS relates to the balance sheet and income statement as a part of a company's financial reports.
  4. Investing

    Evaluating A Statement Of Cash Flows

    The metrics for the Statement of Cash Flows is best viewed over time.
  5. Investing

    Cash Flow On Steroids: Why Companies Cheat

    Pressure to be the best can sometimes push corporations to cheat. Learn how they do it and how to spot it.
  6. Investing

    Cash Flow Statement: Reviewing The Cash Flow From Operations

    A company's ability to consistently generate positive cash flows from its daily business operations is highly valued by investors. Operating cash flow can uncover a company's true profitability ...
  7. Tech

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
  8. Investing

    Understanding the Income Statement

    The best way to analyze a company—and figure out if it's worth investing in—is to know how to dissect its income statement. Here's how to do it.
  9. Investing

    Is Net Income The Same As Profit?

    Net income and profit both deal with positive cash flow, but there are important differences between the two concepts.
  10. Investing

    Fundamental Case Study: Is Amazon's Cash Flow Actually Solid? (AMZN)

    Review Amazon's cash flow situation, including its free cash flow yield, operating cash flow from organic growth and cash flow from debt financing.
RELATED TERMS
  1. Cash Flow

    The net amount of cash and cash-equivalents moving into and out ...
  2. Operating Cash Flow - OCF

    Operating Cash Flow (or OCF) is a measure of the amount of cash ...
  3. Operating Cash Flow Ratio

    A measure of how well current liabilities are covered by the ...
  4. Net Cash

    A company's total cash minus total liabilities when discussing ...
  5. Cash Flow From Operating Activities (CFO)

    Cash Flow From Operating Activities (CFO) is an accounting item ...
  6. Price to Free Cash Flow

    A valuation metric that compares a company's market price to ...
Hot Definitions
  1. Return on Market Value of Equity - ROME

    Return on market value of equity (ROME) is a comparative measure typically used by analysts to identify companies that generate ...
  2. Majority Shareholder

    A person or entity that owns more than 50% of a company's outstanding shares. The majority shareholder is often the founder ...
  3. Competitive Advantage

    An advantage that a firm has over its competitors, allowing it to generate greater sales or margins and/or retain more customers ...
  4. Mutual Fund

    An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities ...
  5. Wash-Sale Rule

    An Internal Revenue Service (IRS) rule that prohibits a taxpayer from claiming a loss on the sale or trade of a security ...
  6. Porter Diamond

    A model that attempts to explain the competitive advantage some nations or groups have due to certain factors available to ...
Trading Center