You must comprehend the distinction between making money and managing money in order to run your business. Growing businesses frequently experience narrower profit margins and rising costs, so trying to “outearn” cash flow issues is not a good idea. Although many business owners excel at selling, it’s time to also become excellent at forecasting and budgeting.
Earnings vs Cash Flow
What is cash flow?
When money enters and leaves a business, it represents cash and cash equivalents. A company has a positive cash flow if it has more inflows, or cash received, than outflows, or cash spent. The company has a negative cash flow when more money is going out than is coming in. The majority of businesses aim to consistently produce positive cash flows. This demonstrates to shareholders and other interested parties that the business can reliably cover its operating expenses while maintaining free cash flow (FCF).
What are earnings?
Earnings are a company’s net income, or the amount left over after all expenses, including taxes, cost of goods sold, and administrative costs, have been deducted from revenue. Companies can use earnings as strong success indicators by comparing them to projections, historical data, and the performance of their competitors. Companies may assess their profits over a predetermined time frame, such as a quarter or a year. Earnings can also be helpful metrics for investors and stakeholders. They appear on the company’s income statement and offer important details about the health and profitability of the business.
Earnings vs. cash flow
Earnings and cash flow are both significant accounting concepts, but they differ in a number of important ways. The differences between earnings and cash flow can be better understood by examining the following areas:
Reporting
Balance sheets, cash flow statements, and income statements are the three financial statements that businesses primarily use to assess the overall performance and health of their organizations. The cash flow statement, which lists the company’s payables and receivables, shows cash flows. Although it resembles a checkbook and depicts the company’s financial activity, the cash flow statement does not always provide a complete picture of all of the company’s costs and activities. As a result, it aids in the reconciliation of the other two statements.
Earnings are listed on the income statement, which displays the business’s profits over a specific time period. Due to the fact that they display a company’s profits after deducting costs and expenses, income statements can provide a more thorough understanding of a company’s performance and potential for growth.
Calculation
Earnings and cash flow are also fundamentally different in terms of how they are calculated. Accounting and financial experts deduct the company’s expenses from its revenue to calculate earnings. Expenses are costs like labor, supplies, rent, taxes and interest. They can use their calculations to display profits for a specific period of time, such as a quarter or a year.
When calculating cash flow, the calculation only takes into account the company’s actual cash inflows and outflows. The cash flow statement won’t reflect anything that happens on a non-cash basis. The statements act as a running ledger up to the period’s end, showing the company’s cash balance.
Importance to stakeholders
When investors and shareholders value a company, they consider its price in relation to its earnings, cash flow, and book value, or equity value. Because of this, understanding earnings and cash flow is crucial, but each provides different insights to stakeholders. Organizations must maintain profits and positive cash flows in order to achieve long-term, sustainable success. However, success in one area does not always translate into success in another.
For instance, a business may be profitable but still lack the cash on hand to pay for necessary expenses like payroll or supplies. For instance, if they are awaiting customer payments or if their inventory has not yet been sold. Profitability is not the same as positive cash flow in this case, and cash flow is more important to stakeholders. Similar to this, a business may temporarily increase its cash flow by borrowing money or selling assets, but it might not have sufficient earnings to be profitable. Here, profits might be more significant, and companies must achieve profitability in order to stay in business.
Insights
These metrics arent just important to valuation experts. They also give important information about the state of the business to analysts and executives. Having consistent cash outflows greater than inflows can hurt operations even if sales are strong. Leaders must use their financial reports to develop plans that will enhance both their long-term circumstances and the health of the company.
Examples of earnings and cash flow
The following examples can help further illustrate the distinction between cash flow and earnings:
Example 1
The Oxbow restaurant agrees to pay the supplier in full within 30 days after purchasing the ingredients for their chicken pot pie on credit. The sum appears as a cash outflow on The Oxbows statement of cash flows on the payment due date. The restaurant uses the ingredients to make pies, which they then sell to bring in money from diners. The sum of these transactions demonstrates the company’s cash flow for the sale of a pie.
The sale of a pie also affects the companys earnings. The profits for that business are the revenue from pie sales less the costs of the ingredients and other expenses. They display these earnings on their income statement.
Example 2
The supplier of the restaurant’s ingredients won’t receive cash until the restaurant pays their bill, in contrast to The Oxbow restaurant, which receives payment at the point of sale of its chicken pot pie. For a while, this could result in the supplier having more cash outflows than inflows. The supplier still views the sale as revenue even though they won’t receive payment for it until later because it affects their earnings.
These illustrations demonstrate how cash flow and earnings can differ depending on how a business is run. Businesses that receive payment in cash at the time of sale may find it simpler to reconcile their books.
FAQ
Why cash flow is better than earnings?
An increase in a company’s liquid assets is indicated by positive cash flow. This makes it possible for it to pay off debts, reinvest in the company, return money to shareholders, cover expenses, and create a safety net against upcoming financial difficulties.
Why are accounting earnings different from cash flow?
This means that a company’s available liquid assets—or the assets that can be quickly converted into cash—are covered by cash flow reports. However, accounting income reflects the total profits and losses that businesses report from their operational activities.
Do Cash flows always exceed earnings?
Cash flows always exceed earnings. Cash flows can be derived from financial statements.
