Reconciliation of profit after Income tax to net cash inflow from operating Activities

Companies need financial statements to gauge and track their financial and operational performance. Financial statements include the income statement, balance sheet and cash flow statement. Due to its relative simplicity, most companies use the indirect method to put together the cash flow statement. However, a few companies use the direct method, even though the information can be difficult to assemble.

Direct Method Description

The direct method presents only those specific items that affect cash flow. This method solely reports cash receipts and cash disbursements in the operating section. Cash receipts include cash received from customers and interests and dividends received. Cash disbursements generally involve cash paid to employees, cash paid to vendors and suppliers, interest paid on debt, federal income taxes paid and cash paid for employee taxes and benefits. The net cash flow equals the difference between these cash receipts and cash disbursements.

Reconciliation Process

Because the direct method solely focuses on cash transactions, the cash flow statement does not have an obvious link to the income statement with this method. Therefore, companies must reconcile the cash flow statement to the income statement through an adjustment and reconciliation process. Under the direct method, reconciliation occurs when a company shows how net income from its income statement translates into the net cash it generated during the same accounting period. After making all the required adjustments, the net income, or net loss, reconciliation must equal the net cash from operating activities shown on the cash flow statement.

Reconciliation How To

To begin the reconciliation process, a company accountant starts with the net income or net loss taken from the income statement and makes certain adjustments to the numbers shown on the income statement or in the short-term assets and liabilities on the balance sheet. She adds back noncash expenses, including any depreciation and amortization shown, provisions for losses that did not actually occur and increases in deferred taxes or taxes payable. Accountants also deduct any gain or add back any loss on the sale of an investment because the investing section already reflects this.

Example -- Cash Flow Statement

A company uses the cash flow method to prepare its statement of cash flows. Its cash flow statement shows $300,000 in cash receipts from customers, $150,000 in cash paid to vendors and suppliers, and $50,000 in cash paid to and on behalf of employees. Subtracting the cash payments from the cash receipts gives the total cash generated by operations of $100,000. The company also paid $20,000 in income taxes. Net cash from operating activities equals $80,000.

Example -- Reconciliation

The company had $70,000 in net income. It made the following adjustments to reconcile net income to net cash from operating activities: added back $5,000 in depreciation; added the increase in accounts payable of $7,000; and recorded a decrease in other short-term liabilities of $2,000. The total adjustments of $10,000 brought the net cash provided by operating activities to $80,000 -- equal to the amount shown on the cash flow statement.

References

Writer Bio

Tiffany C. Wright has been writing since 2007. She is a business owner, interim CEO and author of "Solving the Capital Equation: Financing Solutions for Small Businesses." Wright has helped companies obtain more than $31 million in financing. She holds a master's degree in finance and entrepreneurial management from the Wharton School of the University of Pennsylvania.

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Net income is the profit a company has earned for a period, while cash flow from operating activities measures, in part, the cash going in and out during a company's day-to-day operations. Net income is the starting point in calculating cash flow from operating activities. However, both are important in determining the financial health of a company.

Key Takeaways

• Net income is a key metric of profitability and is a major driver of stock prices and bond valuations.
• Cash flows from operating activities makes adjustments to net income and excludes non-cash items like depreciation and amortization, which can misrepresent a company's actual financial position.
• A company with strong operating cash flows has more cash coming in than going out.
• Still, the net income is the bottom line profit that a company makes and even if a company has positive operating cash flows, it can still lose money when all is said and done.

Net Income

Net income is calculated by subtracting the cost of sales, operational expenses, depreciation, interest, amortization, and taxes from total revenue. Also called accounting profit, net income is included in the income statement along with all revenues and expenses.

Below is the income statement for Exxon Mobil Corporation (XOM) from the company's 2017 10-K statement: 

• Revenue or total sales = $237 billion (blue).
• Total costs and other deductions = $225.68 billion (in red). Total costs include manufacturing expenses of $34 billion, SG&A expenses of $10.9 billion, and $19.893 billion in depreciation costs spread out over years for the purchase of assets like property, plant, and equipment.
• Profit or net income = $19.8 billion (green) after subtracting costs, deductions, and taxes.

Cash Flow From Operations

Cash flow from operations is part of the statement of cash flows. The cash flow statement is a financial statement that summarizes the amount of cash and cash equivalents entering and leaving a company. 

The cash flow statement (CFS) measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses.

Cash flow from operations includes day-to-day, core activities within a business that generate cash inflows and outflows. They include:

• Receipts from sales of goods and services, collected during a period
• Payments made to suppliers of goods and services used in production
• Payments to employees or other expenses made during a period
• Rent payments
• Income tax payments

Cash flow from operating activities also reflects changes to certain current assets and liabilities from the balance sheet. Increases in current assets, such as inventories, accounts receivable, and deferred revenue, are considered uses of cash, while reductions in these assets are sources of cash. Similarly, decreases in current liabilities, such as accounts payable, tax liabilities, and accrued expenses, are considered uses of cash (cash outflow to pay off debt), while increases in these liabilities are sources of cash (cash inflow from the new borrowed capital).

Cash flow from operating activities excludesthe use of cash for purchases of capital expenditures and long-term investments, as well as any cash inflows from the sale of long-term assets. Cash paid out as dividends to stockholders and cash received from a bond and stock issuance are also excluded.

Cash Flow From Operations vs. Net Income

Net income is carried over from the income statement and is the first item of the cash flow statement. Net cash flow from operating activities is calculated as the sum of net income, adjustments for non-cash expenses, and changes in working capital.

However, certain items are treated differently on the cash flow statement than on the income statement. Non-cash expenses, such as depreciation, amortization, and share-based compensation, must be included in net income, but those costs do not reduce the amount of cash a company generates in a given period. As a result, these expenses are added back into the cash flow statement.

Below is the cash flow statement for Exxon Mobil Corporation from the 2017 10K statement: 

• The net income figure of $19.8 billion (green) is the top line of the cash flow statement.
• The depreciation amount of $19.8 billion (blue) was added back into cash flow. If you recall earlier, it was a deduction on the income statement.
• Net cash from operations was $30 billion (red) for the year for Exxon.

Cash Flow Increase From Operating Activities

Companies can increase cash flow from operations by improving the efficiency with which they manage their current assets and liabilities. Rising inventory turnover indicates improving inventory management since it shows low inventory relative to sales and, as a result, becomes a source of cash. 

• Improved account receivable collection practices drive down days sales outstanding, decreasing accounts receivable. If accounts receivable decreases, this implies that more cash has entered the company from customers paying off their credit accounts—the amount by which AR has decreased is then added to net sales. If accounts receivable increases from one accounting period to the next, the amount of the increase must be deducted from net sales because, although the amount represented in AR is revenue, it is not cash. In short, lower days sales outstanding indicates that a company is collecting receivables more quickly, which is a source of cash.
• Growing days payable outstandingis considered a positive development, from a cash standpoint, assuming the company is not incurring borrowing costs or straining supplier relationships. As days payable outstanding grows, cash flows from operations increases.

The Bottom Line

Financial statements, like the income statement and cash flow statement, provide an ongoing record of a company's financial condition and are used by creditors, market analysts, and investors to evaluate a company's financial soundness and growth potential. Both net income and cash flow should be compared with other companies in the industry to obtain performance benchmarks and to understand any potential market-wide trends.

How does depreciation reconcile net income to net cash flows from operating activities?

What is a required reconciliation in the statement of cash flows?

Why is depreciation expense added back to net income to reconcile net income to cash basis?