Free Cash Flow Over Net Income
In this blog, we go over the following:
Why Free Cash Flow is More Important Than Net Income?
Here’s a scenario. Have you ever applied for a loan at the bank? If you have not, typically the bank shows more interest in cash flow compared to the business’s net income. This is not saying that they do not care about net income. Cash flow measures how a company’s ongoing financial health is doing. So, it makes sense that repayment comes from cash flow and not net income. We understand how difficult it is to own a business. Interested in how business owners can manage their cash flow? Financial GPS goes through more on the importance of cash flow, the formula calculation, and how to better make use of the applications in Quickbooks Online. We also took the time to go through how beneficial reviewing the daily cash flow reports can be for each business, common issues, providing free templates, and consider paid tools.
What is Net Income?
Net income, also termed as net earnings or net profit, is the total return after taking out taxes and other deductions from the gross income. In simple terms, it is how much money that is left after all the accounting is done. Here’s the formula and breakdown:
Gross Income
The gross income is the amount of money earned before taxes and deductions are taken out. It is found on the Profit and Loss Statement (see below). For instance, while the monthly salary can be $5,500, however they will still only receive a check for $4,500. In this case, the gross income would be $5,500 and the net income is $4,500.
Revenue and Expenses
Revenue and expenses represent the flow of money through a company’s operations. Revenue is money your company earns from conducting business. Expenses are the costs you incur to generate that revenue. To remain profitable, a company’s revenue must exceed its expenses.
Cost of Goods Sold
Items, products, and services that have been sold is a cost of goods sold (COGS). This is also found on the Profit and Loss Statement. A few COGS examples include: cost of materials, labor, and storage. Business supplies that are not directly used for manufacturing a product are not listed under COGS.
Why Free Cash Flow is More Important Than Net Income?
Yes, net income is every CEO’s priority, however, free cash flow should be just as prioritized - if not more since it helps with many scenarios that business owners face. Here is a blog on why cash flow is the most important element of a healthy business.
Issue Dividends to Owners
Showing the net earnings to a potential investor is important to spike their interest. “If you have high one-time revenue from asset sales, net income is much higher than operating income” (Chron). The only problem with that is it doesn’t show the whole narrative in a business’s financial health. Investors will lean more towards looking at the cash flow of a business to determine if it is the right investment for them.
Emergency Uses
Having a supply of cash set aside for when the business faces difficulties is essential for any company. As a business owner, it is important to be proactive and take the precautions of the worst case scenario no matter how the business is doing. Consider checking the daily cash flow report. Monitoring daily cash flow reports can help you avoid a disaster such as going bankrupt.
Invest in Growth Opportunities
Not only should you set aside cash for emergencies, there should be some wiggle room for new growth opportunities. No business should stay stagnant in one place. It’s important to continue and have fresh ideas to develop any business.
Cash Flow Comes On Top
Over time, having a high cash flow actually boosts net income. In a situation where free cash flow from operations surpasses net income, the company is actually in more of a healthier state than the net income seems. When a business has a strong cash flow, it just shows that the business has strong business operations. This means that there is more cash going into the business than flowing out. Financial GPS as the end of the days strongly advises all business owners to not neglect keeping a close eye with reviewing the cash flow report and working on free cash flow.