Net Income and Accounts Receivable

Net income is not the same as a cash inflow. One reason for this is sales on credit. A sale on credit results in an increase in net income without any actual cash inflow to the company. Cash from sales on credit is only received by the company when the debt is paid by the customer.

Accrual accounting is used by most companies. Accrual accounting recognizes revenue when a sale is made, not when cash is exchanged.

Consider the following simplified income statement for Company A using accrual accounting:

                                                        Income Statement for Year End 2024

Revenue: 1,000,000

Cost of Goods Sold: 500,000

Salaries: 200,000

Rent: 100,000

Utilities: 50,000

Advertising: 10,000

Depreciation Expense: 1,000

Total Expenses: 861,000

Net Income = Revenue - Total Expenses.

Net Income = $1,000,000 - $861,000 = $139,000

Company A has a positive net income. However, because of accrual accounting, revenue from sales on credit can appear on the income statement before cash arrives at the company. Because accrual accounting is used, we do not know how much of the net income has been received as cash.

Cash yet to be received from sales on credit is called Accounts Receivable.

To adjust to cash, subtract accounts receivable from net income:

Cash = Net Income – Accounts Receivable.

As an example, Company A had the above net income of $139,000. Company A made no sales on credit. All of company A’s sales were cash transactions. Thus, accounts receivable is zero. In this simplified example, it is assumed there are no other adjustments that need to be made to adjust net income to cash flow.

Company A cash inflow = Net Income – Accounts Receivable = $139,000 - $0 = $139,000.

Company A has a positive cash inflow equal to its net income. Company A has the entirety of the net income of $139,000 available in cash to pay debts, pay shareholders, or invest in productive assets.

As a second example, Company B also had a net income of $139,000. Company B extended credit to its customers in an effort to increase market share. All of Company B’s customers took them up on their offer of credit. No customers have paid their debt as of year end. Thus, accounts receivable is $139,000. It is again assumed there are no other adjustment that need to be made to adjust net income to cash flow.

Company B cash inflow = Net Income – Accounts Receivable = $139,000 - $139,000 = $0.

Despite a positive net income, Company B has not received any cash from its customers. Credit can be an enticement to increase customers, but it must be extended cautiously. Company B must ensure customers are credit worthy and make provisions for loss of income from customer default. In addition, Company B may incur an opportunity cost by the lack of cash to pay off debts or invest in productive assets. Company B’s ability to repurchase shares or pay dividends to shareholders may also be hindered.

Conclusion: Look at cash flows in addition to net income.

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