This situation may seem a bit counter-intuitive at first, but it is actually quite common and not too difficult to understand. Let's break down the factors at play to examine more closely how a company can have a negative net income and a positive cash flow.
When people talk about net income, they are talking about a number that has been computed by accountants and reported on the company's income statement. In simple terms, a company's annual net income is its revenue, minus all applicable expenses in a given year. If a firm's expenses are greater than its revenue, it will incur a loss for that year, which must be reported on its income statement.
Let's take a closer look at the different types of expenses a company can incur. A typical income statement will include expenses such as depreciation, the use of prepaid expenses, or losses recorded on paper for bad debt expenses. All of these expenses, while they do detract from a company's earnings (as reported by accountants) for the year, are not the kinds of expenses the company actually pays cash for. For example, consider the depreciation of a carmaker's factory and equipment: while this depreciation is indeed a legitimate expense for the company, it does not actually open its coffers and write a check to pay for this depreciation - it is a non-cash charge.
Now, let's say company XYZ had a net loss of $200,000 for the current year. Suppose the company recorded $200,000 in depreciation for the year, used up $100,000 of prepaid expenses (such as insurance premiums) and wrote off $150,000 of bad debts it knew it could never collect. The total value of XYZ's non-cash charges was $450,000, which means its actual cash flow for the year was $450,000 greater than its net income as reported on its income statement. Thus, it actually had a positive cash flow of $250,000 (-$200,000 + $450,000) for the year. Note that the company will not pay income tax for the current year, since it has recorded a net loss, but it actually has more cash on hand than it did at the start of the year. The fact that a company is not earning profits for its shareholders does not necessarily mean it does not have cash on hand to keep paying its bills.
Similarly, a corporation could have a positive net income but a negative cash flow for the year. Let's say a second company, PQR, posted a net profit of $150,000 for the year. However, the company is finding it difficult to pay its monthly bills since it has no cash on hand. How can this be? Suppose PQR bought a new, comprehensive multi-year insurance package in the middle of the year and paid $400,000 cash up front for it. Even though accounting rules only allow the company to claim a small portion of the insurance expense every year, it has paid $400,000 in cash today for many years of insurance coverage in the future. Thus, while the company's accountants must report corporate profits (which are taxable) of $150,000 for the year, the company actually has a negative cash flow for the year of $250,000 ($150,000 - $400,000). If this company is not careful, it may run out of cash to keep its business running smoothly, even though it is making a profit.
Before considering investing in a company's stock or bonds, investors should be aware of the strength of the company's net income and cash flow. After all, what good is it to a shareholder if a company has positive cash flow but repeatedly gets hit with net losses? At the same time, bondholders may find themselves losing their principal if a profitable company doesn't have enough cash on hand to service its debt.
