Net income is just an opinion, but cash flow is a fact

cash flow

Pablo Fernández | There is a financial and accounting maxim which, although it is not absolutely true, comes very close to it and which it is a good idea to remember: “Net income is just an opinion, but cash flow is a fact”. Still today, many analysts view net income as the key and only truly valid parameter for describing how a company is doing.

According to this simple approach, if the net income increases, the company is doing better; if the net income falls, the company is doing worse. It is commonly said that a company that showed a higher net income last year “generated more wealth” for its shareholders than another company with a lower net income. Also, following the same logic, a company that has a positive net income “creates value” and a company that has losses “destroys value”. Well, all these statements can be wrong.

Other analysts “refine” net income and calculate the so-called “accounting cash flow”, adding depreciation to the net income1. They then make the same remarks as in the previous paragraph but referring to “cash flow” instead of net income. Of course, these statements too may be wrong.

The classic definition of net income (revenues for a period less the expenses that enabled these revenues to be obtained during that period), in spite of its conceptual simplicity, is based on a series of premises that seek to identify which expenses were necessary to obtain these revenues. This is not always a simple task and often implies accepting a number of assumptions. Issues such as the scheduling of expense accruals, the treatment of depreciation, calculating the product’s cost, allowances for bad debts, etc., seek to identify in the best possible manner the quantity of resources that it was necessary to sacrifice in order to obtain the revenues. Although this “indicator”, once we have accepted the premises used, can give us adequate information about how a company is doing, the figure obtained for the net income is often used without full knowledge of these hypotheses, which often leads to confusion.

Another possibility is to use an objective measure, which is not subject to any individual criterion. This is the difference between cash inflows and cash outflows, called cash flow in the strict sense: the money that has come into the company less the money that has gone out of it. Two definitions of cash flow in the strict sense are used: equity cash flow and free cash flow. Also, the so-called capital cash flow is used. Generally speaking, it can be said that a company is doing better and “generates wealth” for its shareholders when the cash flows improve.

A company’s Profit after Tax (or Net Income) is a quite arbitrary figure obtained after assuming certain accounting hypotheses regarding expenses and revenues. On the other hand, the cash flow is an objective measure, a single figure that is not subject to any personal criterion.

In general, to study a company’s situation, it is more useful to operate with the cash flow (ECF, FCF or CCF) as it is a single figure, while the net income is one of several that can be obtained, depending on the criteria applied.

Profit after Tax (PAT) is equal to the equity cash flow when the company is not growing (and keeps its customer, inventory and supplier accounts constant), buys fixed assets for an amount identical to depreciation, keeps debt constant, and only writes off or sells fully depreciated assets.

Profit after Tax (PAT) is also equal to the equity cash flow when the company collects in cash, pays in cash, holds no stock (this company’s working capital requirements are zero), and buys fixed assets for an amount identical to depreciation.

The accounting cash flow is equal to the equity cash flow in the case of a company that is not growing (and keeps its customer, inventory and supplier accounts constant), keeps debt constant, only writes off or sells fully depreciated assets and does not buy fixed assets.

When making projections, dividends and other payments to shareholders forecasted must be exactly equal to expected equity cash flows.

*You can read the entire paper here.