You are confusing accrual accounting with tax accounting. Also, inventory is an asset on the balance sheet. Only the change in inventory is recorded as an expense on the income statement. Think about it. Why would inventory on hand be taxed before it is sold? Once you understand the "two-sided" nature of accounting, this will be clear to you.
But the company's net *cash flow* does include money they spend on inventory, doesn't it?
My example was:
- Company grosses $40M per year.
- Company has net positive *cash flow* of $2M
- Year end inventory of $3.4M
- For simplicity in calculating, I was making assumption that ( net income - inventory cost ) = net cash flow.
So income statement will *not* show that $3.4M of inventory as an expense. Without that $3.4M expense, the "net income" of the company now is $3.4M higher than the net cash flow. $2M + $3.4M = $5.4M At 35% corporate rate, that's around $1.9M tax. Effectively the tax wipes out the entire net positive *cash flow* of the company.
I understand as an accountant that might seem fine since tax is on income statement not cash flow. The point I am trying to get across is that for the company the inability to count inventory as an expense is a catastrophe until they reach a very substantial scale (e.g., Target, Home Depot) where they can turn inventory rapidly, or unless the business model avoids most inventory altogether such as with Dell's build to order model. Because for any company without a deep balance sheet, the net positive cash flow after tax of the business *is* the business.
"Will" wrote
Cash flow isn't indicative of profit OR loss. It's only a map of where the money ~came from~ and where the money ~went to~.
A guy goes to the bank and borrows $100,000,000.
Does he have profit?
If not, why? He's got "cash flow".
There are a few times when logic can be found in the tax codes.
That's why a good set of investment financials breaks out four sections in the cash flow:
cash from "Many investors focus on cash flow from operations instead of net income because there's less room for management to manipulate, or accounting rules to distort, cash flow...."
I'm referring to cash flow from operations. And I think most operating managers intuitively understand it is the positive cash flow from operations that really represents the core value of a company.
So again my example is the company makes $40M in sales, $2M in net positive cash flow *from operations*, and has $3.4M in inventory. The inventory does not show as an expense on the income statement, so the net income is raised by $3.4M. I'm ignoring depreciation and assuming $0 capital assets. The 35% corporate tax rate on that $5.4M effectively wipes clean the company's entire net positive cash flow from operations.
He has cash flow from financing, which as you rightly point out is not a sign that a company made money from operations. It's not the kind of cash flow I am referring to.
"Will" wrote
Absolutely. The better investors also look at the income statement as well as the balance sheet.
Because it's not an expense till it gets sold. Why are you having a hard time with that.
Sorry, but it's NOT raised because net income is (or should be) the correct amount of net income from operations - which is always going to be different than net cash flow in any company with inventory, loans, asset purchases, liabilities, receivables, etc.
There is NO income based solely on the remaining inventory.
Try this. New car dealer goes out and buys $1,000,000,000 in new cars. Cash deal - no floor plan financing. The year ends and he hasn't sold a thing, so no deduction for his $1,000,000,000 of inventory still on the lot. No sales means no income, means no profit, means no tax.
Are you with me so far, or have I lost you somewhere.
Dealer sells $10,000,000 of cars for $12,000,000 cash to buyers in year two. With no other expenses he has $2,000,000 of income or profit from those sales. He will be taxed on that $2,000,000 of profit at whatever the going tax rate is for the type of entity he operates the business as. FYI: at 35% that's $700,000.
Are you with me so far, or have I lost you somewhere.
There is no tax - at least no income tax - on the remaining $990,000,000 of unsold cars on his lot.
That the car dealer decided to tie up his cash in that much inventory is a matter to take up with the dealer, not the tax guy.
The way you are responding sounds like you think I am calculating net income independently, and then just arbitrarily raising it by inventory. I'm not doing that. I'm deriving net income backwards from the net cash flow from operations. If net cash flow from operations includes $3.4M of inventory cost and net income should not include that cost, then you have to add the $3.4M back to get back to net income.
I'm not having a hard time understanding it. I'm trying to show by example how the law as written makes it almost impossible for vendors with substantial inventory to do more than break even on a *cash flow from operations* basis, unless they can establish enormous scale and turnover. It's not about understanding how it works. It's about expressing amazement that it is allowed to work that way. If the example I gave with the $40M company doesn't convince you of that nothing will I guess. If you only look at net income it all looks reasonable. When you study the effect on cash flow from operations, it looks devastating.
You say to the car dealer "don't buy $3.4M of inventory" but the way they got the $2M of cash flow from operations was by buying $3.4M of inventory every month. One doesn't exist without the other.
I'm clear on this.
"Will" wrote
What you are doing is taking arbritary numbers and trying to make something out of it.
You are trying to make an example inside a bubble. In your example, where did the money come from to buy the inventory? It didn't come from sales. Initial inventory purchases really can't come from sales.
What gets added or subtracted from net income - or the way you want to do it is by subtracting or adding from cash flow - the ~~~changes~~~ in inventory.
Let's say that beginning inventory was the same as ending inventory. In your example that was $3.4 mil. No change in inventory means no adjustment to or from net income (or from or to cash flow).
Cash flow in your example is $2 mil - which is the same for net income - ending inventory isn't added back.
Are we clear here?
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