Net Income Vs. Cash In The Bank – Why Do They Not Match?

As a business owner, have you ever questioned why your company’s net income looks great, but when you check the balance in your bank account, it is often much lower? The short answer is that your bank balance and net profit will never match. This is a concept that is often misunderstood by business owners and entrepreneurs who are first starting out. To understand why, first it is important to outline the difference between net income and cash flow.

1. Net Income – This is the profit that your business earned over a period of time. This item is found on the income statement. It is the total revenues minus the expenses that were incurred to earn those revenues.

2. Cash Flow – This has nothing to do with your revenue. Rather, it measures your company’s ability to pay expenses. To calculate cash flow, subtract the cash paid out during the period from the cash that was received during the same period. If the remaining cash results in a negative amount, it means that the company is spending more cash than you’re bringing in.

The difference between the positive net income and (often) negative cash flow is essentially an accounting issue. The accounting rules dictate how certain transactions are recorded on the financial statements. For instance, there are several types of transactions that use cash for items that do not appear on the income statement. Therefore, these transactions will only reduce the cash balance in the bank account and not recognize any expenses on the income statement. Additionally, the mismatch between net income and cash flow is caused by the timing difference of when revenues and expenses are recognized in relation to the time payments are collected (cash vs. accrual method of accounting). To learn more about the cash vs. accrual method of accounting, click here for an insightful article.

Below are a few examples of items that use cash, but do not appear on the income statement:

1. Inventory/supplies – For example, you purchased $10,000 worth of inventory that was on sale from a vendor, but only sold $2,000 of that same inventory to customers for the period. The cash account would be reported on the balance sheet as a negative $10,000 and a positive $2,000 for the amount sold to customers. The net effect on the bank balance from purchasing this inventory would be negative $8,000 for the period. The key takeaway for purchasing inventory is that it can only be recognized as an expense as it is sold to customers or through the job costing process when constructing a project or manufacturing goods.

2. Customer who pays for goods or services on credit - When a customer pays on credit, the income statement has revenue but there’s no cash being added to the bank account. Similarly, any cash down payment will be reflected in the cash account and the balance of the customer’s purchase will appear in accounts receivable on the balance sheet. Meanwhile, the entire sale is recognized as revenue on the income statement, reflecting the legal obligation by the customer to pay for the purchase they made on credit. Therefore, in this scenario, the business could show a hefty profit, but there’s been no cash exchanged between the two parties.

3. Purchasing equipment, and other long-term assets with cash – As a business owner who wants to expand, you are likely using cash to invest in assets to fuel your expansion. Most of these types of purchases usually involve an expenditure of cash (i.e. down payments or financing charges). Although you may have a new piece of equipment that is helping you grow your business, the downside is that the expense will not be recognized in the same period as the cash outlay. That is because the accounting standard is to expense the long-term asset gradually through depreciation over the useful life of the assets. (Read more about depreciation here).

4. Repaying a loan - When a loan comes due, your business needs to use its cash to repay the bank. That can decrease your cash account substantially. However, accounting guidelines only allow the interest from the loan to be deducted as an expense when calculating your net income. Therefore, the principal payment lowers the cash account but does not affect net income.

5. Prepaying an Expense – When the business makes a payment in advance, more cash is paid out than the product consumed during the period. The most common types of prepaid items include insurance, taxes, and rent. Depending on which method of accounting your business elects to use (cash vs. accrual) will determine how these expenses are presented on your financial statements. The cash basis will recognize the prepayment in the period that the expense was incurred, while the accrual basis will recognize the expense throughout the of the item purchased.

6. Owner’s Draws / Distributions – Most entrepreneurs who are owners of an LLC or S-Corp are eligible for a distribution. Distributions are a payout of your business’s equity to you and other partners. This money can come from the accumulated profits or from money that was previously invested in the business and is not factored into how much a business owner is taxed. This type of transaction lowers the cash balance in the bank account and does not appear on the income statement as an expense.

To maintain profitability and a healthy level of positive cash flow, our recommendation is to have an annual cash flow forecast prepared in addition to monthly bookkeeping and financial reports. Having an accurate cash flow forecast will typically encompass forecasting, planning, and other action items covering the following 12 months. This complete financial picture of your business will enable you to proactively review your revenues, expenses, and bank balances to ensure that they are all moving in the right direction. If you are looking for more guidance in selecting the best accounting method for your business, contact us today!