The net income stated on the income statement is not the same as the amount of cash in a company's possession. However, net income directly affects the cash presented on the cash flow statement. The information from the income statement links to the information presented in the operations section of the cash flow statement. The relationship between the two financial statements helps to determine how much of a company's net income can result in cash for the firm.
Elements of an Income Statement
The income statement displays the revenue and expenses of a company during a certain period. Revenue primarily derives from the sale of a company’s products or services. A company earns revenue in several different ways, including cash payments and credit sales. Revenue earned through credit sales is unrealized cash until customers pay their invoices. Expenses on an income statement represent money spent in relation to the revenue earned. Companies pay for expenses with cash and through credit. The matching principle calls for companies to realize revenue and expenses when the company incurs them and not at the exchange of cash. The gains and losses on an income statement are the differences between the prices paid for assets and how much the company made from the sale of the assets. Net income or net loss is the total of all revenues, gains, expenses and losses.
Elements of a Cash Flow Statement
The cash flow statement shows exactly how a company makes and spends it cash. Operating, investing and financing activities are the three sections of the cash flow statement. Cash under the operating activities section reflects the cash a company received and spent in reference to the sale of its products or goods. The line items under the investing activities section of the cash flow statement show the inflow and outflows of cash in long-term investments and assets. The financial data presented under the financing activities section reflects cash earned and spent with the company’s issued securities.
The relationship between the income and cash flow statements appears under the operating activities section of the cash flow statement. This section uses information found on the income statement. Therefore, the cash flow statement is prepared after the income statement. The first account under the operating activities section is net income, which is the exact information presented on the income statement for the same period. The next line item after net income is depreciation expense, which also appears on the income statement. To ascertain the net cash amount from operating activities, the company deducts from net income the amount in the depreciation account and changes in certain accounts found on the balance sheet.
A difference exists between profitability and actual cash. Some companies can experience net income, and yet not possess sufficient cash to keep their businesses afloat. Most companies use the accrual basis for recognizing revenue, which causes the cash account to lag behind net income. Transactions within the assets, liabilities and shareholders' equity accounts on the balance sheet also affect the cash account.