Cash Flow vs. Earnings…What’s the Difference? (Part 1 of 2)

This is Part 1 of a two-part series examining the difference between earnings shown on the income statement, and actual cash flow generated from the total business operation during the accounting period.

Yes, there is a difference between your business cash flow and earnings (EBITDA, or net income).  The difference typically arises when a business buys or sells on credit, and the financial statements are presented on an accrual basis (rather than a cash basis).  Growing businesses that sell their goods or services on a credit (receivables) basis, and buy their materials on a payables basis, will likely see a larger difference between its cash flow and earnings.  Why?  Because increasing revenues and positive earnings do not necessarily translate to an increase in cash.  If you have a growing, profitable business, it’s possible you have already experienced this dichotomy.  A business may be profitable on paper, but if it is selling to customers on a credit basis with 30-60 day terms, and paying its suppliers in 15-30 days, it can experience a cash shortfall.  And if the business is experiencing a cash shortfall in its operating cycle, it will likely have difficulty making payroll, covering overhead or repaying debt.

To help explain, let’s look at the analysis that takes place when a financial institution evaluates a business for a loan.  One of the most critical elements to be considered in the analysis is the ability of the business to service, or make the payments on, the amount of the debt under consideration.  While profitability is an element of the analytical process, the primary focus is on cash flow.  The analysis of cash flow used by many financial institutions is referred to as “UCA (Uniform Credit Analysis) Cash Flow”.  This analytical approach dives deeper into the income generating capacity of the business by considering how much cash is actually collected from revenues, and how much cash is actually paid for materials and/or expenses.  It also follows an assumed chronology of the cash generating process by starting with revenues earned during the period and matching with changes in receivables, then matching cost of sales with changes in payables, then deducting operating expenses, then debt service, and finishing up with changes in fixed assets, adjustments for depreciation and then incorporating changes in long term debt.

The key focus of the UCA model is to evaluate the impact on the Cash Account of different areas of the business.   This method evaluates each account on the income statement and balance sheet as either a source or use of cash until all changes in the Cash Account have been accounted for and reconciled.  The actual balance of each income statement account is recorded directly in the analysis, while changes (between periods) in each balance sheet account is recorded. 

The UCA model starts with the analysis of Trading Activities, which focuses on the cash impact of changes in receivables on revenues between accounting periods, and on the impact of changes in payables on cost of sales between periods:

Trading Activities
Revenues	Directly from income statement
(+/-) change in Receivables during the period	( + ) decrease in receivables, is a source of cash ( - ) increase in receivables, is a use of cash
Cash Collected from Sales	Revenues +/- change in Receivables
Less: Cost of Sales	Directly from income statement
(+/-) change in Payables during the period	( + ) increase in payables, is a source of cash ( - ) decrease in payables is a use of cash
Cash Paid to Suppliers	Cost of Sales +/- change in Payables
Cash from Trading Activities	Cash Collected from Sales Less: Cash Paid to Suppliers

 

As an example, if the business recorded revenue of $1 million during the period, but receivables increased by $250,000 during the same period (a use of cash), the actual Cash Collected from Sales is only $750,000.  Further, if cost of sales during the period was $600,000, but payables were also reduced by $50,000 during the same period (also a use of cash), the Cash Paid to Suppliers would be $650,000.  On the income statement, the gross profit shown from this performance would be revenues of $1,000,000, less cost of sales of $600,000, for gross profit of $400,000.  On a UCA Cash Flow statement, the Cash From Trading Activities would be $100,000; the difference in these two approaches is $300,000.  In short, the timing with which the business collects and disburses its cash creates a $300,000 cash reduction compared to a simple review of revenues less cost of sales (see below).

UCA Cash Flow		Net Income
Revenues	$1,000,000	Revenues	$1,000,000
Increase in AR	($250,000)	Less: Cost of Sales	($600,000)
Cash Collected	$750,000
Less: Cost of Sales	($600,000)
Decrease in Payables	($50,000)
Cash from Trading	$100,000	Gross Profit	$400,000

Stay tuned.  There’s more to come in Part II – Cash Flow vs. Earnings…What’s the Difference?  We will complete the full UCA Cash Flow analysis and discuss how it impacts the ability to service debt.