Difference Between Net Cash Flow and Accounting Profit

Edited by Diffzy | Updated on: September 21, 2022

       

Difference Between Net Cash Flow and Accounting Profit Difference Between Net Cash Flow and Accounting Profit

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Introduction

Financial statements are the statements prepared at the end of the accounting period to determine the financial performance, i.e. profit earned or loss incurred during the accounting period, and also the financial position of the business as of the date. Financial statements include trading and profit and loss account, balance sheet, cash flow statements, etc. The trading and profit and loss account shows accounting profit or net profit, the balance sheet displays the assets and liabilities of the corporation at a particular date, and the cash flow statement shows the net flow from operating, investing, and financing activities of the company.

Two terms associated with the above concepts, which are often misunderstood to be the same, are accounting profit and net cash flow. This article outlines the differences between the two and attempts to explain both the terms in detail to present a convincing stand of the difference between the two terms.

Accounting Profit vs Net Cash Flow

The key difference between accounting profit and net cash flow is that accounting profit is simply the revenue of the company minus its expenses, while net cash flow is the difference between the amount of cash generated in operating, investing, and financing activities and the amount of cash used under the three heads. Accounting profit does not indicate the flow of cash in and out of the company; it is a speculative calculation. Since accounting income is based on an accrual basis of accounting, it is not a reliable representation. However, cash flow is based on information, which makes it a more reliable source for comparison with other companies or for comparison with industry norms.

Difference Between Accounting Profit and Net Cash Flow in Tabular Form

Table: Accounting Profit vs Net Cash Flow
Parameters of Comparison
Accounting Profit
Net Cash Flow
Definition
Accounting profit is defined as the actual profit made by the business in that particular year.
Net Cash flow is defined as the result after adding all the inflows of cash and subtracting all the outflows of cash from it.
Elements
Accounting profit includes all the expenses at are specified in the Generally accepted accounting policies (GAAP)
Net cash flow includes cash inflow and outflow under three heads- operating, investing, and financing activities.
Nature
Accounting profit is the standard and prescribed representation of the financial status of a firm.
Net cash flow is a real and more reliable representation of the financial health and status of the firm.
Time
Accounting profit is based on uncertain periods.
Timing is given high importance in the case of net cash flow.
Relevance and reliability
Accounting profit is not a reliable representation as it's based on accrual accounting.
Net cash flow is a reliable and factual representation of the inflow and outflow of cash.
Capital Budgeting
Accounting profit does not aid in capital budgeting decisions.
Net cash flow aids in capital budgeting decisions by showing how much cash is used and generated from the activities of the firm.
Method
Accounting income is calculated based on the revenues and expenses of the firm.
Net cash flow is calculated based on cash inflows and outflows under three heads – operating, investing, and financing.

What is Accounting Profit?

Accounting profit is defined as the actual profit made by the business in that particular year. It includes all expenses prescribed by GAAP.

Format for calculation of Accounting Profit

PARTICULARS

I revenue from operations.

II Other income

III Total revenue

IV Expenses

Cost of materials consumed

Purchase of stock in trade

Changes in inventories of finished goods

Work in progress and stock in trade

Employee benefit expenses

Finance costs

Depreciation and amortization expenses

Other expenses

Total expenses

V Profit before tax (III-IV)

AMOUNT (IN RUPEES)

Revenue from operations means the revenue earned by a company from its operating activities.

II Other income means income earned by a company from its non-operating activities.

III Total revenue is the sum of revenue from operations and other income.

IV Expenses

  1. The cost of materials consumed means the cost of raw materials and other materials used in the manufacturing of goods.
  2. Purchase of stock in trade means stock purchased for reselling.
  3. Changes in inventories of finished goods, work in progress, and stock in trade means the difference between opening and closing stock of final products, work in progress, and stock in trade.
  4. Employee benefit expenses mean payments made to and for the benefit of employees.
  5. Finance costs mean costs incurred by the company on borrowings and expenses incurred for borrowings.
  6. Depreciation and amortization expenses are the gradual fall in the value of tangible and intangible assets.
  7. Other expenses are the expenses that are not covered under the six heads specified above. They may be shown as direct and indirect expenses.

What is Net Cash Flow?

Net cash flow is the result after adding all the inflows of cash and subtracting all the outflows of cash from it. It takes into account revenues and expenses only when they are paid or received and not when they are earned or incurred.

Nature and objectives of calculating net cash flow

A Cash flow statement showcases the inflow and outflow of cash and cash equivalents from different activities of a joint stock company during a particular period.

The primary objective of calculating net cash flow is to provide useful information about cash inflows and outflows of a corporation during a specific period under various heads, i.e. operating, investing and financing activities. This information is used to provide users of financial statements with a basis to assess the ability of the company to generate cash and cash equivalents and the needs of the corporation to utilize those cash flows. The economic decisions taken by users require a thorough evaluation of the ability of an enterprise to produce cash and cash equivalents as well as the timing and certainty of their generation.

Benefits of estimating Net cash flow

  1. A cash flow statement, when used with other financial statements, provides insightful information that enables users to determine the effect of changes in the net assets of a company, its financial structure (which includes its liquidity as well as solvency), and its ability to affect the amounts and timings of cash flows to adapt to the changing business environment.
  2. Cash flow information is used to assess the ability of a corporation to generate cash and cash equivalents and also enables users to develop standards to assess as well as compare the current value of the potential future cash flows of various companies.
  3. It also improves the comparability of the reporting of the operating performance of different companies because it eliminates the effects of using vastly different accounting treatments for the same transactions and events.
  4. It also helps in fine-tuning its cash inflow and cash outflow, keeping in response to changing conditions. It is also used to check the validity of past assessments of projected cash flows and to inspect the relationship between profitability and net cash flow, as well as the impact of changing prices.

Cash and Cash Equivalents

One of the essential concepts that one should have a clear understanding of while calculating net cash flow is cash and cash equivalents.

A cash flow statement showcases inflows and outflows of cash and cash equivalents from several activities of a company during a specific time. According to AS-3- "Cash comprises cash in hand and demand deposits with banks, and Cash equivalents means short-term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value." Any investment generally qualifies as a cash equivalent only when it has a short maturity, i.e. of three months or less since the date of acquisition. However, investments in shares are excluded from cash equivalents unless they are in substantial cash equivalents.

Classification of cash and cash equivalents for calculation of net cash flow:

  1. Operating activities- Operating activities are the activities that constitute the primary activities of an enterprise. These are the principal revenue-generating activities (or the main activities) of the enterprise and other activities that are neither investing activities nor financing activities. The amount of cash generated from operations indicates the internal solvency of the company. Cash flows from operating activities are mainly derived from the primary activities of the enterprise.
  2. Investing activities- investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. Investing activities are those activities that are associated with the purchase and sale of long-term assets or fixed assets such as machinery, Separate declaration of cash flows arising from investing activities is considered significant because they represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.
  3. Financing activities- Financing activities relate to long-term funds or the capital of an enterprise. Financing activities are defined as those activities that result in a change in the size as well as the composition of the owners' capital (including preference share capital in the case of a corporation) and borrowings of the joint stock company. Distinct disclosure of cash flows arising from financing activities is significant as it is used in forecasting claims on future cash flows by owners of the funds to the enterprise.

Main Differences Between Accounting Profit and Net Cash Flow in Points

  1. Accounting income is calculated as Total revenue – Total expenses of the firm. Net cash flow is calculated as the difference between all inflows and outflows of cash of the company. It is presented under three heads-operating, investing, and financing activities.
  2. Accounting profit is the standard and theoretical representation of the financial health of an enterprise, while net cash flow is the actual representation of the financial health of the enterprise. Net cash flow is a more reliable representation of the firm’s performance.
  3. Accounting profit is calculated in uncertain periods, whereas the time factor is given a lot of importance while preparing the cash flow statement.
  4. Accounting profit is not a reliable representation. This is because it is based on an accrual basis of accounting which means that it records receipts and payments when they become due, whereas net cash flow is a more realistic representation of cash flows and is hence a more reliable representation. This is because net cash flow is calculated on the basis of cash basis of accounting which means that it records receipts and payments when they are received or paid.
  5. Accounting profit does not assist in long-term investment decisions, while net cash flow is a great help for long-term investment decisions. This is possible as net cash flow presents a clear picture of cash flows generated and used in financing activities.
  6. Accounting profit does not indicate cash inflow and outflow, while net cash flow indicates the same.
  7. Accounting profit is a speculative calculation; it provides only an estimate, while the net flow is a factual calculation and is more realistic and presents a more reliable picture of the firm without showcasing window dressing,

Conclusion

Two terms commonly used in accounting are accounting profit and net cash flow. Both the terms are often used to convey the same meaning, while they are in stark contrast to each other. Accounting profit and net cash flow are both used to examine the financial health and status of a company. Accounting income is the revenue of the company minus all expenses. Net cash flow is the difference between cash inflow and cash outflow examined under 3 three heads- operating activities, investing activities, and financing activities. Accounting profit is speculative, while net cash flow is factual.

This article has effectively explained the differences between accounting profit and net cash flow to reach a clear understanding of the two terms. It has also given the format for the calculation of accounting income and explained the various items considered while calculating accounting income. It further explains net cash flow along with its nature, objectives, and benefits, as well as cash and cash equivalents and crisp definitions of operating, investing, and financing activities.

References

  1. Class 12 NCERT accountancy textbook volume 2
  2. Class 12 T S Grewal aid to accountancy volume 3

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"Difference Between Net Cash Flow and Accounting Profit." Diffzy.com, 2022. Sun. 25 Sep. 2022. <https://www.diffzy.com/article/difference-between-net-cash-flow-and-accounting-738>.



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