One of the most confusing concepts to understand for entrepreneurs with no finance background is the difference between cash and income. In this article we discuss the three reasons that drive the discrepancy.
Reason #1: Non-Cash Expenses on the Income Statement
The income statement is a financial statement that you use to calculate how much income your company generates. Naturally, the more expenses you can deduct, the lower your taxes are. As a result, companies deduct as much as the IRS allows, and some of those deductible expenses are non-cash.
Two of such non-cash expenses are depreciation and amortization and are related to the use of fixed assets. The IRS allows these deductions to encourage companies to invest into their business. While the actual cash outflow for those investments happens at the time the purchase is made, the non-cash deductions occur over a period of time those assets are used.
The third non-cash expense is called bad debt expense. It is present only when companies extend credit to their customers and is an estimate of the write-off, or the amount they anticipate they won’t be able to collect.
Reason #2: Accrual Accounting
Accrual accounting is the method commonly used for creating financial statements. Under this method, we record revenues and costs when they are incurred, and not when the cash transfer takes place. For example, if the company allows its customers to pay on credit, it will record revenues when the sale is made, but will only receive cash when the customer pays later.
Reason #3: Cash is Spent On Operations, Investing, and Financing
All companies use cash in three ways: operations, investing, and financing. Cash flow from operations is most closely connected with the income statement, but it is not equal to net income for the reasons described above. In addition, companies use cash on investing activities (asset purchases or sales) and financing activities (receiving or re-paying investments and shareholders distributions).
To learn more about the basics of accounting and financial analysis, we recommend you take Class #1 - Financial Statements and Analysis For Early Stage Software and Service Startups.