Case Study: Case of Net Income Not Matching Cash

Just because you made a profit doesn’t mean you created that much in cash. Many find that out at tax time. Now some know why this is, but many don’t. So disregard this if you know. However, if you’ve wondered about it, then let me share a few “whys” with you.

If we buy something for $100 and sell it for $400, we have $300 in gross income. Take away $100 for wages and $100 for overhead like rent and utilities; then we are left with $100 of net income (commonly called profit).

Now why isn’t the $100 net income the same as $100 in cash in the bank?

Depreciation is the Most Common Difference

Ignore Section 179, bonus deprecation, and the IRS mandated MACRS (Modified Accelerated Cost Recovery System) for a moment and consider the transaction in pure form.

Buy $10,000 of equipment with cash in year one. The cash is deducted from our bank, but we’re required to depreciate (recapture the cost of an asset having a useful life for longer than a year) over a number of years.

In year one, out goes $10,000 and we deduct $2,000 depreciation ($10,000/5 years), so our cash is $8,000 less than net income. Year two, however, we take a $2,000 depreciation expense but no cash goes out, so cash is $2,000 more than net income. Same is true in years three through five. After five years, we have deducted the full $10,000 in depreciation so there is no more difference in cash and net income from this transaction.

A couple of things complicate this example. Section 179 allows us to deduct up to 100 percent of the entire purchase in year one. If we pay cash, then the two offset each other. No harm, no foul. However, most of us borrow the $10,000 and the reverse happens.

We get $10,000 from the bank and pay the supplier. To keep the transaction simple, ignore interest and assume it will be paid over five years at $2,000 per year. So year one’s cash is more than our net income by $8,000 ($10,000 depreciation deduction minus $2,000 paid to the bank).

In years two through five, our cash is flipped. We pay our $2,000 each year, but it is not offset by depreciation (all taken in first year), so cash is $2,000 less than income in years two through five. MACRS then adds more math into the calculation, which I ignored to keep it simple. Your professional accountant can help you with this if needed.

In short, decisions on depreciation are the biggest reason net income doesn’t match your cash increase or decrease.

Accounts Receivable: Begin the year with $100,000 in receivables (cash customers owe you). If sales go up, you may end with $125,000 in receivables. That additional $25,000 comes from your cash account. So, increasing sales often means you’re short of cash, even though net income looks good.

The flip is true as well. Decreasing sales often means collecting older receivables without replacing them, so receivables often go down (e.g.: $100,000 to $75,000). The difference of $25,000 is added into your cash account, again making cash different than net income.

Accounts Payable: This is trickier but acts in the opposite way. Payables are the amounts we borrow from vendors. An increase in payables adds to our cash just as a decrease uses cash.

Inventory: The only time you get your money out of inventory is when you decrease it. If you start with $5,000 in inventory and end with $10,000, it means $5,000 has been sucked out of cash, forcing net income and cash to differ.

Withdrawals: Additional money withdrawn (distribution, dividend etc.) by you from your business does not affect net income. This is not to be confused with salary. So you can earn $5,000 and withdraw $10,000 and you will still owe taxes on $5,000 even if the cash isn’t there.

Confused? I highly recommend having your professional accountant prepare a Statement of Cash Flows. That will tell you absolutely, positively where the cash went. In the meantime, net income does not equal your cash increase and these are a few of the reasons. And that’s why it takes more than looking at that one number to see the health of your business.

Tom Crouser is a QP senior contributing editor and principal of Crouser & Associates, Inc., 4710 Chimney Drive, Charleston, WV 25302, 304-965-7100, www.crouser.com. For a financial analysis and cash flow budget for your business, go to http://crouser.com/shop/cash-flow-budget/. Receive his weekly newsletter and participate in surveys at http://crouser.com/panel/. Message Tom at [email protected] and follow his tweets at www.twitter.com/tomcrouser.