Tag Archives | Income Recognition

Cash Flow vs Net Income

See Also:
Operating Income (EBIT)
Free Cash Flow Analysis

Cash Flow vs Net Income

What is Cash Flow?

Cash flow is the blood of a business. It is the measure of what cash is coming in and what is leaving. Cash flow is a more accurate measure of whether a company has enough capital to sustain itself. For example, a company can be extremely profitable and still go out of business due to poor cash flow.

In planning a new business, cash flow is still a very important concept to focus on. Different services and habits affect cash flow. For example, a company’s payment terms greatly affect the amount of cash flowing in and out of a business. If it gives terms that are long, the business could have trouble meeting its other financial obligations. If the terms are short, it can give the business terrific cash flow.

The difference in length of terms comes down to the sizes of accounts receivable and inventory. If a business’s accounts receivable is high relative to its revenue, it is a sign of cash flow problems. Furthermore, if a company has a large inventory account, it can also be a sign of poor cash flow. A large inventory could show a purchasing problem that siphons cash faster than it is needed. Either way, if a business has too much tied up in inventory, it causes cash flow problems. The balance sheet and income statement might show a profit, but cash flow shows whether a business can sustain itself.

Cash Flow Statements

Cash flow statements are broken down into three areas. The areas are operating activities, investing activities, and financing activities. The idea behind separating these sources of cash is to get a better idea of where the cash is coming from. A detailed cash flow statement shows what amount came from loans, products/services, and investments. This can be very useful to investors and lenders.

What is Net Income?

Net income is calculated by subtracting total expenses from revenue. This is the ‘profit’ that most people refer to. Within the total expenses to be subtracted from revenue, overhead and cost of goods/services are both included. This means that net income is the measure of whether a company actually made money during a period. Due to accrual accounting, net profit does not automatically mean a business has cash. However, net income is efficient at tracking business done within a period. This makes net income a better estimate of profitability than cash flow.

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Cash Accounting vs. Accrual Accounting

See Also:
Accrual Based Accounting
Generally Accepted Accounting Principles (GAAP)

Cash Accounting vs. Accrual Accounting

There are two different types of accounting that businesses use: cash accounting vs. accrual accounting. Most businesses use accrual accounting, but it varies by the type of business. These two methods are both legal and accepted by the Internal Revenue Service. The primary difference between the two is when income and expenses are recorded in the books. When thinking about cash basis accounting, picture a lemonade stand. When thinking about accrual basis accounting, imagine a grocery store.

Define Cash Basis Accounting

Cash accounting is simply recording transactions in the books when money changes hands. This excludes accounts payable, accounts receivable, and anything that has not caused a monetary transaction. A lemonade stand would use cash accounting because of its simplicity. The books of a small juice stand would not reflect payables on credit from suppliers. It would not show an anticipated receivable from customers. Another example of a cash accounting business might be a consultant. By deciding the most tax-friendly times for payments and expenses during the year, a consultant can minimize taxes due. This is not tax invasion; it is just deciding when he or she will collect payments for his or her services.

Some argue that this method fails to adhere to the matching principle. In cash accounting, revenues and expenses from the same period are not recorded as accurately. For example, if you sell 100,000 widgets in December but receive payment in January, cash basis accounting will recognize that revenue in January—the next accounting year. This can have unwanted effects on how much taxes are due.

Define Accrual Basis Accounting

Accrual accounting is the widely-accepted method for most businesses. In fact, some businesses require that they use accrual basis, depending on the amount of sales. When they are made, accrual basis accounting records transactions. Record sales before the money enters the company even if the product or service was sold on credit. It also means to record expenses as they are accrued.

Here’s another example to exemplify the difference: a company decides to purchase all new inventory. The entire purchase is realized even if it is not paid for yet. Think of the implications of this at the end of a year. A company could make a large purchase at the end of the year to minimize the taxes due for that period. This will increase revenue, and therefore taxes, for the following year. This example shows it is possible to distort the matching of income and expenses using accrual basis as well as cash basis accounting.

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Valuation Methods

See Also:
Financial Ratios
Required Rate of Return
Internal Rate of Return Method
EBITDA Valuation
What is a Term Sheet?
Adjusted EBITDA
Multiple of Earnings
Business Valuation Purposes

Valuation Methods

There are a variety of approaches to valuing a firm and its equity. The two most popular approaches are discounted cash flow (DCF) methods and market earnings multiple based methods.

Discounted cash flow methods generally project future expected cash flows, discount the value of each of those flows to present value using a discounted rate, and then take the sum of those discounted values to represent the total value of the firm or the total value of the equity. This Free cash flow to the firm (FCFF) method arrives at a total firm value. Free cash flow to equity (FCFE) values the total equity in a firm.

Market earnings multiple methods typically project out a future adjusted earnings amount for the next twelve months. This earning amount typically uses EBITDA (earnings before interest, taxes, depreciation, and amortization) or net income and then multiplies that earnings estimate by a multiple which is within the range of what other similiar firms have sold for in recent transactions.

Valuation Methods Synopsis

As one might expect, valuations can often become complex. The subject of the proper discount rate has spawned numerous books itself. Valuation can also bring up contentious issues, particularly when the ownership interest represents a controlling stake or there is a less than liquid market for that interest.

When a valuation becomes complex, it is standard practice to consult with a valuation firm. Need help finding one? We will get you connected with one of our strategic partners for your valuation needs. Fill out the form below to get connected:

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Realized and Unrealized Gains and Losses

See Also:
Accounting Income vs Economic Income
Capital Gains
Proforma Earnings
Operating Income
Net Income
Asset Market Value vs Asset Book Value

Realized and Unrealized Gains and Losses

In accounting, there is a difference between realized and unrealized gains and losses. Realized income or losses refer to profits or losses from completed transactions. Unrealized profit or losses refer to profits or losses that have occurred on paper, but the relevant transactions have not been completed. An unrealized gain or loss is also called a paper profit or paper loss, because it is recorded on paper but has not actually been realized.

Realized income or losses are recorded on the income statement. These represent gains and losses from transactions that have been completed and recognized. Unrealized income or losses are recorded in an account called accumulated other comprehensive income, which is found in the owners equity section of the balance sheet. These represent gains and losses from changes in the value of assets or liabilities that have not yet been settled and recognized.

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Realized – Unrealized Examples

Example 1

If a company owns an asset, and that asset increases in value, then it may intuitively seem like the company earned a profit on that asset. For example, say a company owns $10,000 worth of stock. Then the value of that stock rises to $15,000. On paper, the company made a paper profit of $5,000. However, the company cannot record the $5,000 as income.

This unrealized gain will not be realized until the company actually sells the stock and collects the cash. Until the stock is sold, the paper profit of $5,000 can only be recorded as an unrealized profit in the accumulated other comprehensive income account in the owners’ equity section of the balance sheet.

Once the company actually sells the stock, the unrealized gain is realized. Only after the stock is sold, the transaction is completed, and the cash is collected, can the company report the income as realized income on the profit and loss statement.

Example 2

Similarly, if a company owns an asset, and that asset decreases in value, then it may intuitively seem like the company incurred a loss on that asset. For example, say a company owns $10,000 worth of stock. Then the value of that stock plunges to $5,000. On paper, the company suffered a paper loss of $5,000. However, the company cannot record the $5,000 as a loss on the income statement.

This paper loss will not be realized until the company actually sells the stock and takes the actual loss. Until the stock is sold, the paper loss of $5,000 can only be recorded as an unrealized loss in the accumulated other comprehensive income account in the owners’ equity section of the balance sheet.

Once the company actually sells the stock, the unrealized loss becomes realized. Only after the stock is sold, the transaction is completed, and the cash changes hands, can the company report the loss as a realized loss on the income statement.

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realized and unrealized gains and losses

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realized and unrealized gains and losses

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Operating Income (EBIT)

See Also:
Operating Income Example
EBITDA Definition
Net Income
Free Cash Flow
Operating Profit Margin Ratio
Time Value of Money (TVM)

Operating Income (EBIT) Definition

Earnings before interest and tax, also know as operating income (EBIT), is defined as a measure of a company’s profit from ordinary operations, excluding interest and tax. EBIT is also called net operating income, operating profit, or net operating profit. Calculate it using the following equation: revenues minus cost of goods sold (COGS) and other operating expenses.

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Operating Income Explanation

Operating income is a measure of company operations. It is also one of the most common financial ratios used for valuing a company as a whole. Therefore, it is very valuable, as well, as a measure of the success of a company from period to period. Additionally, it is the measure of the ability of a company to cover costs and make profit. Operating income ratios leaves out interest and taxes, so it does not serve as a net value of the wealth created from a business. More, it is a general tool used to evaluate the operating process and efficiency which ultimately lead to company profits.

One of the overall advantages of using operating income (EBIT) over other financial ratios is in the simplicity and standardization of calculation. Though interest and taxes play an important role in the financial health of a company they do not, generally, make or break the model for success. When evaluating operating income vs net income, ask whether you need a measurement of company operations as a whole or company operations as they lead to profit.

Operating Income Formula

The operating income formula provides a simple calculation for evaluating common business models. Calculating this equation is fairly simple when one has three values: revenues, cost of goods sold, and operating expenses.

Operating Profit = Revenues – (COGS + Operating Expenses)

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Operating income (EBIT)

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Operating income (EBIT)

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Accounting Income vs Economic Income

See Also:
Economic Income
Accounting Income Definition
Income Statement
Operating Income
Net Income
Future of the Accounting Workforce
Variance Analysis

Accounting Income vs Economic Income Definition

Accounting income or loss recognizes realized gains and losses, and does not recognize unrealized gains and losses. Economic income or loss recognizes all gains and losses, whether realized or unrealized.

When the related transaction is settled or completed, gains and losses are realized. Until a transaction is completed, any gains or losses related to that transaction are considered unrealized. Unrealized gains and losses are also called paper gains or paper losses, because the nominal value of the asset or liability has changed, but the cash has not actually changed hands.

Accounting Conservatism

Accounting income or loss does not incorporate unrealized gains and losses because of the convention of conservatism. When accountants confront uncertainty in regard to method or procedure, they conventionally choose the option that is least likely to overstate income or asset value. In the case of realized versus unrealized gains and losses, it is more conservative to exclude increases or decreases in value that have not yet been actualized.

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Accounting Income vs Economic Income Example

Here is a simple example dealing with an individual regarding accounting income vs economic income. Imagine Ralph earns $50,000 dollars per year salary, after tax, and has $10,000 dollars invested in the stock market. At the end of the year, his stock market investment is worth $15,000.

Because Ralph has not yet sold his stock and collected the profits, the increase in value of the investment is considered unrealized. Consequently, it is a paper profit. At the end of the year Ralph has a realized income of $50,000 from his salary. His total realized income is $50,000. He has unrealized profits of $5,000 dollars. His combined realized and unrealized incomes equal $55,000.

In this example, Ralph’s accounting income would be $50,000 and his economic income would be $55,000. According to accounting income, the increased value of the stock investments do not count as actual income because the investor has not actually sold the stock, completed the transaction, and collected the profits.

According to economic income, the increased value of the stock investments to count as actual income because the real value of the assets has gone up. The assets are worth more now then they were at the beginning of the year. In this sense, Ralph has earned the full $55,000 income.

Mark to Market Accounting Income

There are exceptions to the methodology of reporting net income, based solely on the historical cost of acquired assets. US GAAP includes the principle of “Mark to Market Accounting.” Under this accounting principle, valuation of commodities, securities and other financial instruments on a company’s balance sheet are based on the market values of such assets.

For example, if the cost of a precious metal acquired by a company for use in its production process, such as using silver to produce a catalyst used by the petrochemical industries was $10 per troy ounce and the market value of silver increases to $ 15 per troy ounce, the company would value the silver on its balance sheet at $15 per troy ounce. It would also report the increase in inventory value as an element of its net income for the period being reported.

GAAP vs IFRS

Another development in the financial arena is the move towards “IFRS” or International Financial Reporting Standards, which have been adopted by European companies, and which US companies will move to, in order to provide a common measuring stick when comparing earnings per share of publicly traded companies. IFRS mandates adjustment of many assets to a market value, which adjustments would be/ are included in the calculation of accounting income.

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Accounting Income vs Economic Income

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Accounting Income vs Economic Income

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Accounting Income Definition

See Also:
Accounting Income vs. Economic Income
Accrual Based Accounting
Financial Ratios
Comprehensive Income
Financial Accounting Standards Board (FASB)

Accounting Income Definition

Accounting income is an estimate of performance in the operations of a company. It is influenced by financing and investing decisions. Accounting income or loss generally recognizes realized gains and losses, and does not recognize unrealized gains and losses.

For income to be realized it must be related to actual business transactions; in effect, the cash you have must increase or decrease. A change in market value rather than cash received is not an accounting income; it is an economic income. Economic income or loss recognizes all gains and losses whether realized or unrealized.

Whether a gain or loss is realized or unrealized, it is central to the accounting profits definition. It becomes an income suitable for accounting when a gain or loss is realized. The accounting value for this asset is generally listed at the historical value of the transaction selling it. When a gain or loss is unrealized, you may or may not be account for it in general. This depends on the placement of the gaining or losing asset in the balance sheet. Despite that this gain or loss may be accounted for, the fact that it is unrealized makes it an economic income or loss. The accrual accounting income statement will look very different from the fair value accounting statement.

Essentially, accounting income defined the ways companies evaluate their cash standing after the sale of an asset. This, once again, differs from economic income in that economic income is the way for companies to account for changes in the value of a given asset in the market. The deciding factor is whether or not a transaction takes place.

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Accounting Conservatism

Accounting income or loss does not incorporate unrealized gains and losses because of the convention of accounting conservatism. When accountants confront uncertainty in regard to method or procedure, they conventionally choose the option that is least likely to overstate income or asset value. In the case of realized versus unrealized gains and losses, it is more conservative from an accounting perspective to exclude increases or decreases in value that have not yet been actualized.

Accounting Profit Example

A perfect example of accounting profit occurs every day in the stock market. Investco is a company which invests in market securities. Investco currently owns a share of Google stock worth $600. The following week Investco notices the share of Google stock has increased in value from $600 to $650. Investco sells this share of Google stock and receives $650 from the sale of one share of Google stock. What is Investco’s accounting income? Accounting profit and economic profit demonstrate two different principles.

Investco experienced an accounting income: their share of Google stock was sold for $50 more than it was initially worth. Thus, Investco has a realized accounting gain of $50. The accounting income calculation is $650 – $600 = $50.

If Investco never sold the share of Google stock it would have experienced an economic gain of $50. Investco did not have a transaction in which cash increased by $50.

Accounting Income vs Taxable Income

The treatment of accounting income and taxable income is different. The inclusion of tax accounting confuses the matter. Under GAAP, income and expenses are matched to the period in which they are incurred. As a result, the accounting income received was incurred on the specific day that it sold the share of Google stock. With tax accounting, however, match taxable income and expenses to the period upon which the I.R.S. decides. Investco may or may not incur an increase in taxable income based on I.R.S. regulations. It has incurred this potential increase in the accounting period the I.R.S. chooses. Do not consider accounting income under GAAP an accounting profit under I.R.S. tax rules. Want to check if your unit economics are sound?  Download your free guide here.

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