Interpretation of Cash Flow to Net Income Ratio

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Of the three basic financial statements, the balance sheet alone reports on the business’s financial circumstances at one specific moment. The other three -- the income statement, cash flow statement and retained earnings statement -- document one aspect of the business’s performance across a specific period. Income statements note the change in the business’s financial circumstances through the running of its operations for the period in question, while cash flow statements report on the change in its cash and cash equivalents from doing the same.

Revenues and Expenses

A company runs its business in order to produce more revenues than expenses. Revenues are the sums that a business earns through running its operations, while expenses are the sums that a business spends in order to run those same operations. Revenues minus expenses equal the business’s net income, either its financial gain or its financial loss incurred for the period in question.

Cash Flow

Cash flows are changes in a business’s cash and cash equivalents incurred during a particular period. Cash receipts represent cash inflows and cash payments represent cash outflows, while the total resultant change is the net cash flow. Cash flows include non-income transactions based in cash such as cash spent to purchase equipment and machines, but does not include noncash-based revenues and expenses such as depreciation.

Relationship Between Cash Flow and Net Income

A relationship exists between cash flow and net income, but they are separate concepts in accounting. Cash flow is the measure of the business’s liquidity, or the business's ability to pay its short-term debt obligations by the cash or cash equivalents that it has on hand. In contrast, net income measures the business’s profitability, a general measure of how efficiently it uses its resources to produce revenues while keeping ahead of the expenses spent to produce those revenues. Net cash flow divided by net income is not a useful financial ratio because its interpretations are too broad and uncertain.

Interpretation of the Ratio

In general, a net cash flow to net income ratio less than 1:1 indicates that the business takes in less cash and cash equivalents than what it earns in profits, while a net cash flow to net income ratio that is higher than 1:1 indicates that it takes in more cash and cash equivalents than what it earns in profits. Such ratios can be indicative of problems existing in the business’s current practices, but confirmation is difficult without further information. For example, a low net cash flow to net income ratio might mean that a business is not collecting enough cash to meet its short-term obligations with ease, but only looking into its short-term obligations and the collection rate on accounts owed to the business can confirm this.

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