Net Income vs. Operating Cash Flow: An Overview
Financial statements provide a wealth of information about a company and its operations. Many investors, analysts, and creditors refer to a firm's net income and operating cash flows to understand how well a company has performed and used its cash in operations. Net income, also known as the bottom line, is just as its name implies. It is the remaining income—or revenues—after deducting expenses, taxes, and costs of goods sold (COGS). Operating cash flow (OCF) is the amount of cash generated from operations in a specific period.
- Net Income is the result of revenues less expenses, taxes, and costs of goods sold (COGS).
- Operating cash flow is the cash generated from operations, or revenues, less operating expenses.
- Many investors and analysts prefer using operating cash flow as an indicator of a company's health.
- Net income is important to investors and analysts but does not necessarily provide a complete picture of a company's development.
Net income is earned revenues minus incurred expenses, including taxes, and costs of goods sold (COGS). It follows gross income and operating income and is a final monthly, quarterly, or annual report. A net income statement is important for potential investors and creditors, but it does not always show the company's actual development. For instance, after a high, one-time asset sale, monthly net income may be higher than operating income, followed by a much lower quarterly net income.
Operating Cash Flow
Total cash flow is the operative cash flow plus the net working capital of the company. The net working capital is the difference between assets and liabilities. The operative cash flow reports inflows and outflows as a result of regular operating activities. It is the cash from revenues, excluding non-operating sources (e.g., investments and interest). The best demonstration of operating cash flow is the cash cycle, which converts accrual accounting-based sales into cash.
Cash flow and net income statements are different in most cases because there is a time gap between documented sales and actual payments. The situation is under control if invoiced customers pay in cash during the next period. If the payments are postponed further, there is a larger difference between net income and operative cash flow statements. If the trend does not change, the annual report may demonstrate equally low total cash flow and net income.
Usually, rapidly developing companies report low net income as they invest in improvement and expansion. In the long run, high operating cash flow brings a stable net income rise, though some periods may show net income decreasing tendency.
Constant generation of cash inflow is more important for a company's success than accrual accounting. Cash flow is a better criterion and barometer of a company's financial health. Managers and investors can avoid many traps if they pay more attention to operating cash flow analyses.