What is the difference between earnings and cash flow

There are other accounting techniques that can distort earnings. The level of gaming that can be done to earnings makes some investors jittery about trusting earnings.

Even those that are aware of that use earnings in common analysis. It is usually very specific analytic articles that use cash flow. Almost all of them have to explain why they are using cash flow instead of regular earnings. It makes sense though. Earnings are reported at the time the sale is made so they are in the present, and easier to identify.

Cash flow will include money from overdue payments as well, but that would not be a accurate picture of the present. The Case for Cash Flow There are a couple of cash flow methods, but for now cash flow is just a general term for actual cash flowing into the company. Cash flow ignores many accounting measures. For example, depreciation is excluded for most fixed assets, since it is a non-cash charge. The most common specific cash flow measure is operating cash flow.

The narrowing the scope counteracts some of the drawbacks of using cash flow. To contrast net income with cash flow, consider a company with a large amount of expensive fixed assets. Most companies used accelerated depreciation, which reduces earnings since depreciation is a non-cash expense. If the asset is providing a nice return, the company might be bringing in a lot of cash, while having only mediocre earnings.

More on Non-Cash Charges Non-cash charges are something that deserve extra attention. They can present openings, because they do change the quantitative picture, while not necessarily changing the fundamental one. It is not often that fundamental numbers are affected, but the outlook is not that different. Non-cash charges are expenses that have no impact on income or cash flow, but they will reduce earnings. The charges can be recurring like depreciation, or one-time like writedowns.

Writing down assets can push a company into losses, without affect cash flow. If a company writes down an acquisition it completed three years ago, the money is gone.

If that acquisition does not bring in enough money, then the company will keep making the same cash, while pushing itself into the red for earnings. Since the point of a company is to make cash, then a writedown does not really change the health of a business. It is an acknowledgement that the company is not doing the best job with that specific asset. Earnings are still the standard measure most of the market uses.

One-time non-cash charges can skew earnings, while leaving the cash flow untouched. While it might not happen often, and the market might even notice, being aware of the difference between earnings and cash can help identify opportunities.

Cash really helps companies in a rut, because cash is required for innovations. Develop and improve products. List of Partners vendors. Operating cash flow OCF is the lifeblood of a company and arguably the most important barometer that investors have for judging corporate well-being.

Although many investors gravitate toward net income , operating cash flow is often seen as a better metric of a company's financial health for two main reasons. First, cash flow is harder to manipulate under GAAP than net income although it can be done to a certain degree. Second, "cash is king" and a company that does not generate cash over the long term is on its deathbed. But operating cash flow doesn't mean the same thing as EBITDA earnings before interest, taxes, depreciation , and amortization.

While EBITDA is sometimes called a "cash flow," it is really earnings before the effects of financing and capital investment decisions. It does not capture the changes in working capital inventories, receivables , etc. The real operating cash flow is the number derived in the statement of cash flows. The statement of cash flows for non-financial companies consists of three main parts:.

By taking net income and making adjustments to reflect changes in the working capital accounts on the balance sheet receivables, payables, inventories and other current accounts, the operating cash flow section shows how cash was generated during the period.

It is this translation process from accrual accounting to cash accounting that makes the operating cash flow statement so important. The key differences between accrual accounting and real cash flow are demonstrated by the concept of the cash cycle. A company's cash cycle is the process that converts sales based upon accrual accounting into cash as follows:. There are many ways that cash from legitimate sales can get trapped on the balance sheet.

The two most common are for customers to delay payment resulting in a build-up of receivables and for inventory levels to rise because the product is not selling or is being returned. Not only can accrual accounting give a rather provisional report of a company's profitability, but under GAAP it allows management a range of choices to record transactions. While this flexibility is necessary, it also allows for earnings manipulation. Because managers will generally book business in a way that will help them earn their bonus , it is usually safe to assume that the income statement will overstate profits.

An example of income manipulation is called " stuffing the channel. Inventories will then move into the distribution channel and sales will be booked. Accrued earnings will increase, but cash may actually never be received because the inventory may be returned by the customer. While this may increase sales in one quarter, it is a short-term exaggeration and ultimately "steals" sales from the following periods as inventories are sent back.

Note: While liberal return policies, such as consignment sales , are not allowed to be recorded as sales, companies have been known to do so quite frequently during a market bubble.

The operating cash flow statement will catch these gimmicks. When operating cash flow is less than net income, there is something wrong with the cash cycle. However, in the long term, cash flow and earnings should converge as cash is collected or paid. Small businesses with limited financing must not only focus on earnings but also pay attention to cash flow, the actual money resources used to support operations.

Earnings in financial reports are accounting profits that are the results of both cash and non-cash revenues. Companies recognize revenues when earned regardless of cash receipts.

When companies make sales on credit, they record revenues at the time of the sales and thus report earnings before receiving cash payments from customers.

When companies are able to collect the cash later, the amount of cash flow catches up with the earnings number.

But if companies fail in their cash collection, the reported earnings are misleading to a degree. Not all sale-related cash received can be reported as earnings at the time.

Customers may make advanced payments on future sales that companies can recognize as revenue and earnings only over time. As a result, companies may have lower reported earnings at times, while they may show stronger cash flow positions in the meantime.