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What is the difference between net income and free cash flow?
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In this article, I will break down the difference between Net Income vs Free Cash Flow so you know all there is to know about it!
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Difference Between Net Income vs Free Cash Flow
Understanding the difference between net income and free cash flow is important as they measure two very different things.
Net income is a measure of a company’s profit generated in a given period.
On the other hand, free cash flow refers to how much cash is available to the company to spend after it has paid for its capital expenditures.
Both of these metrics are used to determine a company’s profitability and financial performance, but they are different in many ways.
To better understand the difference between net income and free cash flow, let’s look at each concept in more detail.
Net Income Meaning
Net income is a measure of how much a company has generated in profits when you take into consideration the company’s total revenues and deduct all its expenses for a given period.
A company with a higher net income is more profitable than a company with a lower net income.
To determine a company’s net income, you’ll need to take the company’s revenues from all sources and deduct all the expenses the company has incurred during the same period.
In business, many will refer to the net income as the “bottom line”.
Free Cash Flow Meaning
Free cash flow refers to the amount of money or cash available to a company after it has paid for its capital expenditures and financial obligations.
To understand free cash flow, we must first understand the meaning of “cash flow”.
Cash flow is essentially the amount of money coming into a business and going out.
On the other hand, “free” cash flow refers to the amount of money a company has available to spend after it has paid for its financial obligations.
The more a company has free cash flow, the more it has access to capital to invest in the company’s growth or even pay dividends to its shareholders.
Why Net Income And Free Cash Flow Differ
Since both net income and free cash flow are used to measure a company’s financial performance and profitability, at first glance, they may appear similar.
Many consider that a company’s net income represents the free cash available to it to reinvest in the business.
However, that’s not the case.
In fact, net income is an “accounting number” that is adjusted based on cash and non-cash expenses.
In other words, net income is determined by using various accounting principles.
On the other hand, free cash flow calculates the actual amount of money available to a company after it has paid for its capital expenditures.
Another reason why net income is not the same as free cash flow is that many companies use an accrual accounting method where they recognize certain transactions as they occur rather than the actual amount of cash that they receive.
When a company recognizes a sale and has not received payment from the client, it can report the figure on its financial statements as deferred revenues.
However, the deferred revenue does not represent actual cash in the company’s hands.
Net Income vs Free Cash Flow Characteristics
Let’s look at the main characteristics of net income and free cash flow to better understand their differences.
Net Income Characteristics
Net income has generally the following characteristics:
- It is found on the company’s income statement
- A positive net income indicates the company has generated more revenues than it incurred in expenses
- It measures the company’s overall profitability
- It can include operating income or income from one-time or exceptional events
Free Cash Flow Characteristics
Free cash flow has generally the following characteristics:
- It is a measure of how much cash is available to a company in a given period
- It is determined after the company has paid for its financial obligations
- It is used to predict the company’s ability to fund its growth or pay dividends
- It is a better measure of a company’s financial health
How To Calculate Net Income And Free Cash Flow
Net income refers to the amount of profit a company has made during a given period of time.
To calculate net income, you need to take top line revenue and subtract all expenses, interests, costs, and taxes during the same period.
You can use the following formula to calculate net income:
Net Income = Total Revenues – Total Expenses
Net income is a measure of a company’s profitability.
Free cash flow is the amount of cash that a company has generated after deducting non-cash expenses, changes in the company’s working capital, and its capital expenditures.
Free cash flow can be used by the company to reinvest back into the business or pay dividends to its shareholders.
You can use the following formula to calculate free cash flow:
Free Cash Flow = Cash Flow From Operations – Capital Expenditures
The more a company generates free cash flow, the more it is able to maintain its current assets and invest in the future growth of the company.
Reconciling Net Income To Free Cash Flow
Many investors will want to look at a company’s free cash flow to assess whether the company is in good financial health or not.
The reason this is the case is that net income is an accounting number that is used to determine a company’s profitability and can be manipulated using actual expenses or non-cash expenses.
On the other hand, free cash flow is the actual cash available to a company to spend after it has paid for its capital expenditures, such as property, plant, and equipment.
A company can reinvest its cash to maintain its assets, grow its business, pay off debt, acquire other companies, and create more value for its shareholders.
To reconcile net income to free cash flow, here are the steps you need to take:
- Take net income
- Add depreciation and amortization
- Add stock-based compensation
- Add deferred tax liabilities
- Add a decrease in inventory
- Add a decrease in accounts receivable
- Add an increase in accounts payable
- Add deferred revenue
- Subtract excess tax benefits from stock-based compensation
- Subtract gain on sale of property, plant, and equipment, or other assets
- Subtract deferred taxes
- Subtract an increase in accounts receivable
- Subtract an increase in inventory
- Subtract a decrease in accounts payable
- Subtract capital expenditures
So there you have it folks!
What is the difference between net income and free cash flow?
In a nutshell, net income accounts for a company’s profits by taking its total revenues and deducting all expenses, including depreciation and amortization.
Net income is an accounting figure used by financial analysts and investors to assess a company’s overall profitability.
Free cash flow is the amount of cash or money the company has left over after it has paid for its capital expenditures.
The more a company has money available to it to reinvest in the business, the more a company can create value for its shareholders.
Understanding the difference between net income and free cash flow is important as they are both used to assess a company’s financial health and performance by looking at different angles.
Now that you know what net income and free cash flow mean and how they are different from one another, good luck with your research!
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