Income: Is It Cash Flow?

In finance, we constantly hear about “cash flow.” This has to do with one particular reason, which is, only cash can repay debt. Therefore, we are preoccupied with tracing where the borrower’s cash is coming from, since the ability to pay debt will depend on the recurring nature of that source of cash.

So how hard is it to determine cash flow? That is basically income, right? Not necessarily. There are a couple of principles to bear in mind that distinguishes what we call income from cash flow. First, you have the Generally Accepted Accounting Principles (GAAP) which requires capital assets to be depreciated or amortized. Ignoring the reasons for this, what you should understand is the income statement of a business can contain several non-cash expenses that make income appear less than the actual cash flowing through the company.

The opposite can also be true when a large capital purchase is made. The income statement will not reflect the large cash expense to acquire a capital asset in the same year that expense occurred. Rather, only a fraction of that expense will actually be represented on the income statement as depreciation.

Because of GAAP, the income statement may not accurately reflect the true cash flow of the company. It is the duty of the underwriter to uncover which expenses were not actual cash expenses, and which expenses actually occurred that were not necessarily reflected on the income statement.

The other significant reason income cannot be equated to cash flow has to do with our tax system. Taxable income is not necessarily cash income. Individuals must pay taxes on their business income, which we already know is not cash flow because of GAAP. The individuals must pay taxes on that income even if they did not take any cash out of the company, and the individuals must pay taxes on that income even if the owners put money into the company!

Also, keep in mind other unique events happen as well. If people receive non-cash gifts, they must report that as income. If they sell assets at a gain or loss, only the gain or loss is reflected as taxable income, when in fact the cash proceeds from the sale were the actual cash flow. Certain forms of retirement income are not taxed. The list goes on. Just because income is taxable doesn’t mean it is cash in hand.

For these reasons, the underwriting process is not as simple as looking at an individual tax return or a business P&L. Rather, the underwriter uses these tools as a basis for analysis, and will likely formulate questions to be asked to the borrower to determine which sources of income can be counted as cash and which can’t. This may involve requesting K-1s for partnerships, which disclose cash exchanged between owners and their businesses. The underwriter will need to ask questions clarifying how cash moves to and from the individual from their accounts or other individuals, or how cash moves in and out of the business for operating purposes. This is because income, not cash, is what is being explained on income statements and tax returns.

In short, it would be easy and a luxury to be able to build a cash flow simply by using a tax return, or by assuming reported net profits are cash available for debt service. Unfortunately, the world we live in is full of caveats and special considerations. GAAP is not concerned with reflecting actual cash on income statements, and the IRS does not tax on a cash basis alone. It takes an understanding of both GAAP, IRS rules, the unique circumstances affecting the individual, and the operations of each business to truly determine what is occurring on an actual cash basis. --Trevor Plett