Net income is the profit a company has earned for a period, while cash flow from operating activities measures, in part, the cash going in and out during a company's day-to-day operations. Net income is the starting point in calculating cash flow from operating activities. However, both are important in determining the financial health of a company.
Net income is calculated by subtracting the cost of sales, operational expenses, depreciation, interest, amortization, and taxes from total revenue. Also called accounting profit, net income is included in the income statement along with all revenues and expenses.
- Revenue or total sales = $237 billion (blue).
- Total costs and other deductions = $225.68 billion (in red). Total costs include manufacturing expenses of $34 billion, SG&A expenses of $10.9 billion and $19.893 billion in depreciation costs spread-out over years for the purchase of assets like property, plant, and equipment.
- Profit or net income = $19.8 billion (green) after subtracting costs, deductions, and taxes.
Cash Flow from Operations
Cash flow from operations is part of the statement of cash flows. The cash flow statement is a financial statement that summarizes the amount of cash and cash equivalents entering and leaving a company.
The cash flow statement (CFS) measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses.
Cash flow from operations includes day-to-day, core activities within a business that generate cash inflows and outflows. They include:
- Receipts from sales of goods and services, collected during a period
- Payments made to suppliers of goods and services used in production
- Payments to employees or other expenses made during a period
- Rent payments
- Income tax payments
Cash flow from operating activities also reflects changes to certain current assets and liabilities from the balance sheet. Increases in current assets, such as inventories, accounts receivable, and deferred revenue, are considered uses of cash, while reductions in these assets are sources of cash. Similarly, decreases in current liabilities, such as accounts payable, tax liabilities and accrued expenses, are considered uses of cash (cash outflow to pay off debt), while increases in these liabilities are sources of cash (cash inflow from the new borrowed capital).
Cash flow from operating activities excludes the use of cash for purchases of capital expenditures and long-term investments, as well as any cash inflows from the sale of long-term assets. Cash paid out as dividends to stockholders and cash received from a bond and stock issuance are also excluded.
Cash Flow From Operations vs. Net Income
Net income is carried over from the income statement and is the first item of the cash flow statement. Net cash flow from operating activities is calculated as the sum of net income, adjustments for non-cash expenses and changes in working capital.
However, certain items are treated differently on the cash flow statement than on the income statement. Non-cash expenses, such as depreciation, amortization, and share-based compensation, must be included in net income, but those costs do not reduce the amount of cash a company generates in a given period. As a result, these expenses are added back into the cash flow statement.
- The net income figure of $19.8 billion (green) is the top line of the cash flow statement.
- The depreciation amount of $19.8 billion (blue) was added back into cash flow. If you recall earlier, it was a deduction on the income statement.
- Net cash from operations was $30 billion (red) for the year for Exxon.
Cash Flow Increase from Operating Activities
Companies can increase cash flow from operations by improving the efficiency with which they manage their current assets and liabilities. Rising inventory turnover indicates improving inventory management since it shows low inventory relative to sales and, as a result, becomes a source of cash.
Improved account receivable collection practices drive down days sales outstanding, decreasing accounts receivable. If accounts receivable decreases, this implies that more cash has entered the company from customers paying off their credit accounts – the amount by which AR has decreased is then added to net sales. If accounts receivable increases from one accounting period to the next, the amount of the increase must be deducted from net sales because, although the amount represented in AR is revenue, it is not cash. In short, lower days sales outstanding indicates that a company is collecting receivables more quickly, which is a source of cash.
Growing days payable outstanding is considered a positive development, from a cash standpoint, assuming the company is not incurring borrowing costs or straining supplier relationships. As days payable outstanding grows, cash flows from operations increases.
Financial statements, like the income statement and cash flow statement, provide an ongoing record of a company's financial condition and are used by creditors, market analysts, and investors to evaluate a company's financial soundness and growth potential.
Net income is a key metric of profitability and is a major driver of stock prices and bond valuations. The cash flow from the operating activities section demonstrates the adjustments made to net income.
Unlike net income, operating cash flow excludes non-cash items like depreciation and amortization, which can misrepresent a company's actual financial position. A company with strong operating cash flows has more cash coming in than going out. Additionally, companies with strong growth rates or improving cash flows are more likely to have a stable net income, be able to increase dividends, expand operations, and weather economic downturns.
Both net income and cash flow should be compared with other companies in the industry to obtain performance benchmarks and to understand any potential market-wide trends. (For related reading, see "Is It Possible to Have Positive Cash Flow and Negative Net Income?")