Finance focuses on cash flows as the priority rather than earnings. Net Income and earnings per share (EPS) are accounting numbers designed to reflect how much profit the firm is making according to Generally Accepted Accounting Principles (GAAP). The purpose of net income is to recognize income when it is earned and expenses when they are incurred. Cash flow instead looks at when money comes into the firm and when it goes out. Both measures are important and have a purpose, but in finance the emphasis is on cash flows. The reason for the focus on cash flows is three-fold.

First, a company must have cash to succeed. Employees need to be paid, inventory must be purchased, utilities must be paid, etc. Consider a company that sells a 10-year magazine subscription with your payment due at the end of the subscription time (yes, this is a greatly exaggerated example, but that is intentional to help make the point clearly). Each issue that is shipped will be recognized as revenue and help the company with its net income, yet the company is not getting paid. Therefore, the company will look good on an earnings basis, but is destined for bankruptcy. Why? Because it must pay printing costs, shipping costs, editorial costs, etc, yet it is receiving no cash. After a short time it will not have enough cash to pay its bills. What about credit? Credit is a tool that can allow firms to operate on negative cash flows for a short period, but eventually the creditors will want paid as well and then only cash will do.

The second reason has to do with timing of cash flows and their value (The Time Value of Money which is covered in Chapter 4 ). The revenues are worth more to the firm the sooner they are received (since the money can then be put to use by the firm) and less the later they are received. The expenses are less costly the later they are paid (since the firm can retain use of the money longer) and are more costly the sooner they are paid. Consider the purchase of a long-term asset (such as a printing press) that is expected to be useful for ten years. Under GAAP, the expenses will be spaced out over the press's useful life (depreciation). Thus, the initial expense will not be recognized at the purchase, but proportionately over ten years. Meanwhile, the firm must pay for the equipment today, not over ten years. Thus, the cash expense is at the point of purchase. Then, there is no cash expense over the next ten years. Accounting income, understates the cost in the initial year and overstates it each additional year. This is reasonable for the purpose accounting is trying to achieve, but it results in an incorrect recognition of the present value of the cost of the equipment. Time Value of Money is critical to maximizing firm value and earnings don't allow us to recognize it correctly while cash flows do, which is why we must focus on cash flows.

The third reason to be wary of Net Income and Earnings per Share (EPS) is that they can be manipulated. There are many discretionary decisions that firms make that impact how and when they recognize expenses and revenues (thus impacting net income and EPS). For example, consider inventory. Again, consider a simple, exaggerated example. XYZ Corp is a widget retailer. They currently have 4 widgets on inventory that (due to changing market prices) cost them $100 for the first widget, $200 for the second widget, $300 for the third widget, and $400 for the fourth widget. They sell all widgets for $450. If they sell two widgets and use LIFO (Last In, First Out) as an inventory method, their income will be $200 ($450*2 - $400 - $300). On the other hand, if they use FIFO (First In, First Out), their income will be $600 ($450*2 - $100 - $200). The FIFO method generates much higher income, but does not result in higher cash flows. Alternatively, LIFO will have lower income, but result in higher net cash flows as the firm will pay less in taxes. Another example is depreciation. If a company shifts from a 3-year depreciation period to a 5-year depreciation schedule, their depreciation expenses will decline resulting in a higher net income. However, it does not increase their cash flows. Actually it will have no effect on cash flows for most firms as many use straight-line depreciation for their financial statements and an accelerated depreciation method (MACRS) for tax purposes. There is considerable evidence that many firms use their discretionary accounts to "smooth" income and make it more predictable as this makes it appear less risky. While cash flows are not entirely immune to manipulation, they are less likely to be manipulated than Net Income and EPS numbers.

The above three reasons are why we must focus on cash flows over net income or EPS. However, this does not say that Net Income or EPS are meaningless or "wrong" numbers. In most cases, firms that increase EPS will also increase cash flows. NI and EPS can provide us with information and does serve the purpose it is created for (matching revenues earned and expenses incurred), but when we have both numbers, we are better served by focusing on cash flows over EPS.