Cash flow is the lifeblood of any SMB. But you need to track both Net Income (NI) and Free Cash Flow (FCF) in order to fully understand your business.

This also includes understanding when these two measures differ and why.

So this week, I’m talking all about Net Income vs. FCF:

• What they are

• What they mean

• How they’re calculated

• And when they differ

Let’s get into it.

What They Are

Both Net Income and Free Cash Flow measure the amount of capital that a firm can either distribute to its owners or invest back into the business.

While Net Income is simply the difference between Revenues and Expenses, both contain non-cash line items. And depending on the accounting methods being used, the result here might be somewhat misleading.

Free Cash Flow, on the other hand, excludes non-cash expenses and includes spending on assets, as well as changes in working capital. As a result, this amount more accurately reflects the cash that a business can safely distribute or invest. For this reason, free cash flow can be also a better indicator of a firm’s financial health.

What They Mean

Net income, or your “accounting profit” is almost always a distorted figure thanks to the tremendous amount of leeway that accounting teams have when it comes to revenue and expense recognition.

As a result, a positive Net Income may not guarantee true profitability.

In these cases, Free Cash Flow can provide the missing context. This is because FCF shows how your business handles collections, working capital, and capex.

Not only does positive FCF more reliably denote a company’s ability to invest in growth, but it can also detect problems in the business before they would ordinarily appear on the income statement.

What do I mean by this?

Because Free Cash Flow accounts for changes in working capital, growing inventory balances or longer cash collection periods would paint a less rosy albeit more realistic picture of what’s actually going on than Net Income.

But for its many advantages, there is one notable drawback to Free Cash Flow. Because this measure accounts for investments in property, plant, and equipment, your FCF can appear somewhat lumpy over time.

How They’re Calculated

Net Income (NI)

Net Income = Total Revenues - Total Expenses

Free Cash Flow (FCF)

FCF = NI + Interest Expense + Non-Cash Items - Changes in Working Capital - Capital Expenditures (Capex)

At a high level, FCF differs from Net Income in that it excludes the non-cash expenses recorded on the income statement and includes the changes in working capital and capital expenditures reflected on the balance sheet.

When They Differ

Both Revenue and Expenses from Net Income contain non-cash components.

This leads to differences in your Net Income and Free Cash Flow.

While relatively mature companies in stable industries tend to have very similar NI and FCF, both high NI and low FCF, as well as low NI and high FCF, can occur for a number of reasons.

High NI and low FCF

This can occur if you have:

• High margins, poor collections

• One-off events such as asset purchases, legal losses, etc.

• High margins, high debt levels

Low NI and high FCF

This can occur if you have:

• Depreciation accounting that affects your NI but not your cash flow

• High R&D investment (expensed on the income statement)

• An asset-heavy business with high D&A that generates a ton of cash

Putting It All Together

Here are your top takeaways from this week’s post.

1. You need to track both Net Income and Free Cash Flow to fully understand your business.

2. Because Free Cash Flow accounts for changes in working capital, it can identify issues in the business before they appear on the income statement.

3. Net Income = Total Revenues - Total Expenses.

4. Free Cash Flow = Net Income + Interest Expense + Non-Cash Items - Changes in Working Capital - Capital Expenditures (Capex).

5. Your NI and FCF can differ as a result of the non-cash items that make up Net Income.

6. High NI and low FCF can occur when you have high margins but poor collections, one-off events like asset purchases or legal losses, or high margins and debt levels.

7. Low NI and high FCF can occur when you have depreciation accounting that affects your NI but not your cash flow, high R&D investment expensed on the income statement, or an asset-heavy business with high D&A that also generates lots of cash.

Hungry for More?

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2. Shoot me an email with your questions or requests for what you’d like me to write about next.

‘Til Next Time,

Connor