Income statements measure and can be used to forecast profitability. Cash flow statements measure and can be used for forecast cash levels. These two financial statements need to be understood by the small business owner. It is possible for a company to show a great profit, yet struggle due to poor cash flow and management. Below are some major differences between the two statements.
Accrual System of Accounting
Some businesses use an accrual system of accounting as opposed to a cash system. The main issue has to do with the timing of the recognition of revenues and expenses. Generally, in the accrual system, revenues are posted when the product or service has been delivered to the customer and the customer has been billed. However, payment terms are not taken into consideration. This means that revenue has been posted to the income statement, but no actual money (cash) has been received and deposited.
The same process can hold true for a company’s expenses. Expenses can be posted on the income statement before they are actually paid.
Owner Distributions and Draws
These are not posted to the income statement as an expense, therefore, draws and distributions do not effect profitability, but they certainly effect cash flow. For more detail on this subject, please click here.
Generally, loan payments are a combination of principal and interest. Only the interest portion is posted as an expense on the income statement. The principal portion is not posted to the income statement, therefore, it does not affect profits. However, both the interest portion and principal portion will effect cash flow.
Capital Purchases and Depreciation
The cost of capital purchases may be different from the depreciation expense allowed on the income statement. The full cost of capital purchases will effect cash flow. Depreciation is a non-monetary expense and will effect reported profits, but not cash flow.
Other areas that effect the income and cash flow statements in different ways include loan or investor proceeds, purchases of intangible property, amortization and prepaid expenses.
The small business owner needs to understand the differences between the income statement and the cash flow statement. The survival of their business could depend on it. Cash is King!
If you need help understanding these differences, contact us today for a free beginning consultation.