In finance, you will often hear about two measures that accountants, analysts, and investors refer to the most when they review a company’s financial health: Net income (also known as earnings, or net profits) and free cash flow (FCF). Both metrics are measures of profitabilty and financial performance. But what exactly seperates free cash flow from net income and why are they different?
In summary, net income represents the profits of a company from an accounting standpoint and thus includes non-cash expenses such as depreciation & amortization. Free cash flow, on the other hand, measures the actual cash flow that is available to shareholders. It does that by adding back the non-cash charges to net income, adjusting for changes in working capital, and subtracting out capital expenditures.
What’s Net Income?
Net income is the amount of profit that a company has reported over a certain time period. In theoretical concept, it is the top line revenue after subtracting all the costs, expenses, interest payments, and taxes that are associated with those revenues and operations during the measured period. The following formula for net income is pretty straightforward:
Investors and analysts usually keep a close look at the net income figure of a firm since it represents the accounting profit that is left within the business after stripping away all corresponding expenses from the company’s revenue. Because of that, net income is a fundamental metric that can have a primary impact on stock prices as it measures a company’s ability to generate profits.
What’s Free Cash Flow?
Free cash flow is the amount of cash that a company has generated after adjusting for non-cash expenses, changes in working capital, and capital expenditures (CapEx) such as property, buildings, and other physical assets. Free cash flow represents the amount of cash that a company has at the end of the day which could theoretically be distributed to shareholders and creditors.
While both measures provide key insights into a company’s profitability, they can still heavily differ from each other. In some cases, a company can have a negative free cash flow while reporting positive net income or the other way around.
Why Are Net Income and Free Cash Flow Different?
If you go through the income statement of a company for the first time, you might assume that net income is the amount of cash that a company will hold at the end of the day after accounting for all expenses. This isn’t the case in most of the times.
The problem here is that net income is an accounting number that is adjusted based on various accounting principles and therefore doesn’t reflect the actual cash flow, that a company gets to keep at the end of the day. The result is that any given amount of net income reported by a company can be very different from its actual amount of free cash flow.
Why Net Income Doesn't Equal Cash Flow
In order to fully understand where the difference lies between free cash flow (FCF) and net Income, we need to clarify how both net income and free cash flow are being computed.
Net Income doesn’t represent the actual amount of cash flow that could theoretically be distributed to the company’s shareholders, due to the nature of accounting. The standard accounting practice for nearly all companies is what’s called accrual accounting where businesses are required to recognize transactions as they occur instead of when there is an actual amount of cash being paid or received by the business.
For instance, when a business has made a sale on a product at the end of a fiscal year but hasn’t received the actual amount of cash yet, it will still need to report the amount of unrealized revenue on the balance sheet as deferred revenue.
Accounting Incorporates Non-cash Expenses
The second factor that makes net income inherently different from cash flow is how expenses are classified. In accounting, the expenses of any company are categorized into three types:
- Operating Expenses are expenses that are incurred by a business through its standard operations during the year such as labor, rent, or maintenance. Within an income statement, operating expenses are deducted from the gross revenue to come up with operating income.
- Financial Expenses are any expenses that are associated with the use of debt financing. Within the income statement, financial expenses such as interest payments are deducted from operating income to arrive at net income.
- Capital Expenditures include expenses that a company makes to buy, maintain or improve assets. Capital expenses are expected to provide benefits over many years in the future.
Unlike operating and financial expenses, capital expenditures don’t show up in the income statement: Any type of capital expenditure isn’t directly deducted from revenue even if it occurred during the reported time period but is instead spread out over time as what is called depreciation and amortization.
If for example, a clothing manufacturer has built a production facility in a given year, the costs for the construction are recognized as capital expenditures and don’t get subtracted from the revenues in the income statement.
What happens instead is that the business will only subtract out a fraction of the cost each year for the next few years as depreciation which in return shows up as a part of the operating expenses.
Depreciation is a primary example of what are called non-cash expenses. Non-cash expenses represent those expenses that appear on the income statement even if they don’t involve any cash transaction.
So why do accountants spread out capital expenditures? Since capital expenses usually provide benefits to a business for many years to come, they can’t be accounted for just the revenues in the year that they occur.
A clothing manufacturer company doesn’t build a factory just to use it until the end of the year. Instead, the factory is expected to provide a productive use for a considerable amount of time into the future. The same applies to other physical assets such as equipment, buildings, and machinery but also intangible long-term assets like patents and licenses.
How Are Net Income and Free Cash Flow Being Computed?
Having a look at the income statement of a business quickly gives us the net income figure of the recent year. Free cash flow, on the other hand, isn’t directly stated within the financial statements but we can easily calculate it on our own with the numbers stated on the cash flow statement of a business.
Example: Microsoft Corporation
Calculating Net Income
In the following, we will go through the income statement of Microsoft (MSFT) to demonstrate which line items are deducted from the top line (revenue) in order to arrive at the bottom line (net income). Afterward, we will take a look at the cash flow statement to calculate Microsoft’s free cash flow for the recent fiscal year
Source: Microsoft SEC Filings
Microsoft had total revenues of $143,015m in the most recent fiscal year ending June 30. Subtracting out the total cost of revenue ($46,078m) leads us to a gross profit of $96,937m. From that figure, operating expenses such as R&D, Sales and Marketing, and G&A are subtracted to arrive at operating income of $52,959m. The last step is to adjust the operating income with other income gains and deduct taxes of $8,755m, which finally leads us to a total net income of $44,281m
Calculating Free Cash Flow
Here is the cash flow statement for Microsoft based on the company’s recent 10-K filing:
Source: Microsoft SEC Filings
What we can notice is that the statement of cash flow starts with the net income on the top. From there, non-cash expenses such as depreciation and amortization are added back to net income, while adjusting for changes in working capital. What’s left is the net cash that has been generated from all operations of the business also known as operating cash flow.
Microsoft had cash flows from operations of $60,675m. Now we deduct the capital expenditures which Microsoft defines as additions to property and equipment of $15,441m from the operating cash flow to get to a free cash flow of $45,234m for the fiscal year ending in June 2020.
Conclusion
Both net income and free cash flow are similar in the regard that they measure a company’s profitabilty, but the net income figure of a business doesn’t represent the actual cash flow of the company.
In order to get from the net earnings that are stated at the bottom of an income statement to free cash flow three steps need to be taken:
- Adding back non-cash expenses to the earnings such as depreciation and amortization
- Adjusting for changes in working capital
- Subtracting out the capital expenditures that have been made within that year.
As a result, the profits (net income) of a business can often be very different from the actual cash flows: One company can have positive earnings but negative cash flows because of high reinvestment costs, while another firm might have negative earnings but positive cash flows due to fewer capital expenditures and higher depreciation that is added back to net income.
