A company's net income seems like a simple concept that measures how profitable a business is. However, many investors have the misconception that net income automatically translates to an increase in net cash on a company's balance sheet. In reconciling net income to changes in net cash, several adjustments are needed to reflect items that are used in calculating net income but don't have an impact on cash levels. Specifically, there are four categories of accounting items you should look at when reconciling net income and net cash.
Some accounting items are included in net income even though they don't involve actual cash changing hands. Examples include depreciation and amortization of assets, asset impairments, and unrealized gains or losses on foreign-exchange translations. In order to figure out changes in net cash, you have to back these items out of the net income figure.
Changes in the value of operating items
Cash isn't the only asset that a company has. In some cases, net income isn't converted into cash because of delays between the time the company bills the customer for a good or service and the time the company receives payment from the customer. Similarly, accrued expenses are included as a charge to net income, even if they're not paid until later.
To adjust for changes in operating assets or liabilities, add back any decrease in operating assets or any increase in operating liabilities. Then subtract any increase in operating assets or any decrease in operating liabilities. This accounts for the impact of operations on non-cash items like accounts receivable and accounts payable.
Asset and investment purchases and sales
Purchases and sales of business assets for internal investment have an impact on cash, even though they typically don't affect net income directly. In this case, any cash spent on business assets must be accounted for by decreasing the net cash line item, and any cash received from the sale of business assets will increase net cash. Note that to the extent that immediate deductions for certain business asset investments are available, the deduction to net income will match the cash spent, allowing the two to offset perfectly.
Borrowing or paying off loans also has an impact on cash without affecting net income. If the company borrows cash, then you'll have to add the amount borrowed to net cash in order to make it balance. Similarly, if the company pays down debt, then you'll subtract the principal payment from net cash.
Reconciling net income to net cash might seem silly when the balance sheet shows you exactly how much cash a company has. Nevertheless, knowing how to do the work by hand can help you discover any discrepancies that might arise in the companies that you're considering.
If you're ready to begin your investing journey, check out The Motley Fool's Broker Center to get started today.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!