Starting with revenue, various expenses are subtracted. These include cost of goods, research & development, interest paid, and taxes paid. After all the expenses have been taken out, net income is what remains. Sometimes, the expenses are more than revenue, so net income is negative. Not a good thing if it persists.
Net income does not equal cash
Because companies use the accrual method of accounting, they have to follow its principles. One of the most important principles is what is known as the matching principle. Under this, expenses are matched against the revenue they help generate. But that doesn't necessarily mean that the cash spent is matched against the revenue. Let's take an example.
If you spend $1,000 to buy inventory for your clothing store during the quarter and sell all the clothing that same quarter, then that entire expense is charged against the revenue for that quarter. However, if you manage to sell clothes that only cost you $800, only $800 of that $1,000 is charged against that quarter's revenue. The remaining $200 will be charged against the next quarter's revenue. Note, though that $1,000 actually left your checking account this quarter. But the expense was only $800.
Next quarter, you buy only $600 worth of clothes, but again sell clothes that cost you $800. Your expense again is $800 -- $600 from the cash you spent during the quarter and $200 from the cash you spent the previous quarter. That $200 is a non-cash expense for this quarter. The cash was spent in the earlier quarter. This is the matching principle in action, matching the expense to the revenue.
There are several other types of non-cash expenses that must be matched against the revenue they generate. One of these is depreciation, the "burning up" of the value of an asset, such as a delivery truck, which was paid for much earlier, but is still being used to help generate revenue. All of these expenses, cash and non-cash alike, must be deducted from revenue on the way to determining net income.
Remember (or refresh yourselves), too, that revenue doesn't equal cash. Some of those clothes you sold might have been sold on credit for which you are still awaiting payment of cash. But that revenue is counted in the quarter (or year) in which the sale took place.
In order to determine the actual cash flowing through the business, refer to the cash flow statement. It is possible to have negative net income while being cash flow positive (and vicy versy).
Net income and manipulation
This is another way in which the accrual method and GAAP can come into play.
Because net income is a GAAP term and does not represent the actual cash coming into the business, it can be manipulated somewhat easily. Within generally accepted accounting principles (the rules under which company books must be kept and reported), management has a fair amount of leeway. For instance, when it recognizes revenue, how much depreciation to take and when, and when various expenses are charged are all ways to, well, "fake" is too strong a term (most of the time), so let's say, "adjust" net income. (There are other ways -- see Quality of Earnings by Thornton L. O'Glove.)
The stock price can live or die based on how well or closely the company matches or beats the expectations of Wall Street (see below) and in many companies, management bonuses are tied to things like earnings per share (EPS). Shareholders want an always rising stock price. Wall Street wants the company to "make" its numbers. Managers would like those bonuses. So there is a lot of pressure from many different sources to potentially massage net income so that it comes out as it "should."
An example: For 10 years while Jack Welch was CEO of General Electric, can you guess how many times it missed quarterly earnings estimates? Go on, guess (and no fair peaking at the source above). The answer is twice. Out of 40 quarters, it met or exceeded earnings expectations 38 times. Given the vagaries of business and the economy, does that seem reasonable or is it possible that there was some (perfectly legal and all within GAAP) manipulation going on?
Now not every company (or even most) manipulates its earnings. But be aware that net income is not the "pure number" it is so often portrayed as being.
Net income, Wall Street, and estimates
Net income and its cohort, EPS, is probably the most watched number on Wall Street. Stock prices rise and fall, sometimes a lot, when companies report their earnings. Analysts spend inordinate amounts of time pestering, er ... talking to company management to be "guided" on what the company will make next quarter, this year, next year, and (sometimes) analyzing the company to predict those numbers themselves.
At first glance, this seems reasonable. Management, after all, has the best view of how the company is doing. But have you ever watched how quickly analyst estimates change and, more importantly, what value they change to after a company upgrades or downgrades guidance? Companies always give guidance in the form of a range of values. Analyst estimates are almost always within that range, sometimes with a few outliers. And they change almost the moment management changes guidance.
That raises some questions: Are the analysts actually analyzing the companies and industries, spotting trends, noticing inventory piling up or items selling briskly, etc.? How often do they change their estimates based on what they see, learn, and know? And how often do they only change their estimates when management says so? One way to find out is track when analysts change their estimates (through sites like Yahoo! Finance's analyst opinion) and compare that to when companies change their guidance.
David Gardner Explains
- Gross income
- Balance sheet
- Earnings per share
- Income statement
- Net margin
- Operating income
- Statement of cash flows
- Cost of goods sold
Recent Mentions on Fool.com
- Why Nordson's Shares Dropped
- 5 Reasons to Worry About Next Week
- German Banks Fall as Slowdown Fears Intensify
- Are Triple-S Management's Earnings Worse Than They Look?
- Why the Street Should Love Gartner's Earnings
Discuss this article on the Net income board.