For many small business owners, having money in the bank means that they have made money and everything is going well.  The problem comes when the owner has no money in the bank and he goes to his accountant that tells him he has made money and will have a large tax bill in April.

“What do you mean I’ve made money this year, I don’t have any money in the bank, where did it go?”  The bank balance is a part of the cash flow of the business and not necessarily the net income from the business, the whole cash flow vs profit margin thing.  So, positive cash flow does not necessarily mean you have positive net income and vice versa.

I can boil my job down to 3 questions that I need to answer for all of my clients and this helps to explain the difference between cash flow and net income:

  1. How much money did I make? (Net Income)
  2. Where did it go? (Cash Flow)
  3. How much tax will I pay?

How They’re Different

So how are cash flow and profit related? We start by looking at the Net Income of the business.  We can usually find this on the Profit &Loss, also known as an Income Statement.  It shows the gross sales minus the cost of goods and operating expenses to arrive at a net income or bottom line.  Let’s say for example that number is $50,000.

So naturally, you might assume that the bank account would be $50,000 larger, but this may not be the case.  What if you carry inventory and you have $30,000 more on hand at the end of the year than at the beginning?  That means that $30,000 of that income would be sitting on the shelves and maybe $20,000 went back into the bank account.  What if you have accounts receivable and they went up $50,000 over the course of the year, you would have made the $50,000, but have no cash to show for it.  The same could be said if you purchased any large equipment or other assets, you would have less in the bank, but still would have net income.  These and other adjustments are found in the Cash Flow Statement.

Loans and Equipment

I think one of the hardest things to explain to business owners, is when the business has debt and starts making money.  You pay down debt with the cash flow; however, loan payments are not expenses (only the interest portion of the payment can be deducted).  This causes a disconnect between cash flow versus profit as you pay down loans you decrease cash flow which has NO effect on the “bottom line”.

Equipment and the related depreciation is also a common non-cash expense that causes trouble.  Specifically with accelerated depreciation for tax purposes.  Section 179, for instance, allows the write-off of most of your equipment purchases in the first year, lowering your net income for taxes.  In subsequent years, you may still be paying the loan for that equipment, but will receive no additional expense for taxes.  The dreaded cash flow out with not tax deduction.

Read more in the Section 179 Trap

This is where good planning with an accountant can be crucial. Understanding the difference between cash flow and net income can help to stop big tax surprises and can help you better plan for the future and manage your business more efficiently.

We Are Here To Help

Our Tulsa CPAs along with our Oklahoma City CPAs want to help you make and keep more of YOUR money, by helping you with your monthly bookkeeping, payroll and tax needs. Find out more today by contacting our offices in Oklahoma City: 405-720-1244 or Tulsa: 918-477-7650!