Whether or not you’ve taken accounting, you probably already know the concepts of income and “profit”. Income is just how much you earn that goes directly to your pocket, whether from a salary or a business or both. On the other hand, loosely put, profit is more specific in that it is how much you earn from a business… it is your sales less your costs and expenses. This is why profit is sometimes referred to as “net” income.
However, you have to be careful when using the term profit or net income. It means you earn, but it doesn’t necessarily mean that you earn any actual cash. Why? Let’s say you sell a watch to someone. He picks up the watch from your shop and he promises to pay you $100 cash after 1 month. Do you record on your books that the sale happened today or one month later? Surprise, surprise! Based on generally accepted accounting principles (GAAP), you should record that the sale was made today. Not next month. Therefore, you can also already book your profit today… even if you didn’t earn any actual cash yet. This type of profit is called “accrued” income. You earn income even without collecting any cash yet.
This is where the difference between a Net Income Statement and a Free Cash Flow Statement comes in. A Net Income Statement shows net income, based on cash income and accrued income as well as both cash expenses and accrued expenses. A Free Cash Flow Statement shows free cash flow based on all the actual cash which the company earns, minus all the cash payments the company actually makes. A Free Cash Flow Statement does not take into account accrued income, and it does not take into account accrued expenses which have not yet been paid for in cash.
Moreover, a Net Income Statement does not reflect cash payments for capital (like for the company’s building, property and equipment) but the Free Cash Flow Statement reflects these payments as long as these payments were (already) done in the form of cash.
It can be said that the Net Income Statement and the Free Cash Flow Statement represent 2 different philosophies. So who follows which philosophy? Basically, accountants prefer to use the income statement in reporting company earnings. The government normally looks at your income statement as well when it wants to calculate how much taxes you should pay. On the other hand, modern financial managers generally prefer to look at the Free Cash Flow Statement as a true measure as to “how well the company is doing”, believing that income isn’t really income unless you actually earn cash.