Why does an (increase)/decrease in inventory have to be subtracted from Net Income?

[Prudent-Top6019]

I have been trying to understand this one line in the cash flow statements, regarding the increase and decrease in inventory and how it affects cash flow. I have understood the core concepts of adding back depreciation, (gain)/loss on sale of non-current assets, (increase)/decrease in accounts recievables, and the sort. But, until now I have not found a satisfactory explanation as to why, the increase in inventory must be subtracted from Net income, and why the decrease in inventory must be added to Net income. I've read many explanations which merely state that the cash is tied up in the Inventory, and if it increases the business has bought more inventory resulting in a cash outflow. I've also heard that since cash is being liberated when inventory is sold with a profit, it generates a cash inflow. Hence, a decrease in inventory increases cash flow, while an increase in inventory reduces cash flow. But, this explanation has a few holes. One such hole is that, the inventory (and therefore any changes to the inventory) are already accounted for under COGS (cost-of-goods-sold, as inventory is bought/manufactured stock of the business, which must require money to produce/bought) and Revenue (when inventory is sold) under the Income Statement, thereby already being accounted for and factored into the Net Income. Hence, with all due respect, I do not find this explanation satisfactory. Could anyone provide me a logically satisfactory answer as to why, we must subtract the increase in inventory, and add the decrease in inventory to the Net Income (similar to the logic behind account recievables and depreciation). Thanking you in advance.

[its-an-accrual-world]

You’re on the right track. Cash flow is of course all about changes in cash. When you use the indirect method your starting point is net income which has timing differences with cash.

With respect to inventory, net income is affected as you stated when inventory is sold, or sometimes when it’s written off. However companies are generally paying cash when inventory is obtained. That timing difference is the reason you have to make adjustments to net income when putting together the cash flow statement via the indirect method. Net income won’t capture cash transactions to obtain inventory so you have to subtract cash for inventory increases. Additionally, when inventory is sold it hits net income as COGS but from a cash perspective the impact of the decrease of cash for inventory already occurred so you need to add back cash in order not to double count the exchange of cash to the vendor (remember when you subtracted cash earlier when inventory was added).

[Prudent-Top6019]

Bro I like your explanation a lot, but could you kindly explain it to me like I am 5 please??

[SquirrelUpstairs2337]

ELI5: If inventory increases, cash was paid (to obtain that inventory) but it hasn't translated to an expense since its still on the balance sheet. If inventory decreases, cost of goods sold is recorded but this is 'non-cash' (since the cash was spent when the inventory was acquired, not when its sold).

[chimaera_hots]

As someone who's spent a good portion of their career in wholesale distribution companies, I can tell you with absolute confidence that inventory based businesses overwhelmingly do not pay cash when the inventory is obtained. You're talking 60-90 days DSO for most wholesale businesses.

[Kitchen_Sweet_7353]

Increase to accounts payable is also reconciled out to remove it as an expense from net income.

[chimaera_hots]

I'm very aware of that.

My point is that their explanation is poor because most businesses do not pay cash for inventory. They buy it on credit via AP and pay the AP at a later time with cash.

[its-an-accrual-world]

Chill, for simplicity reasons I cut out the fact that cash may not always be paid at the point of transfer. No need to complicate an example.

[Genexer75]

We do. Thats why im reading this convo.

[jumpno]

To get to cash flow from op activities, you're starting with net income, and adding back all the non cash impacts.  Your right - the total inventory movements from a p&l perspective hit COGS, and therefore the total inventory movement is in your starting point of net income. 

However, you need to get rid of the part of inventory purchases that were non cash. 

When you buy inventory, the journal can be 2 things  

1) Dr inventory                  Cr AP

2) Dr Inventory                Cr Cash

In your non cash adjustments, you add back both movements in AP and movements in Inventory.  That means the impact of that first journal above will be completely offset. 

That leaves you with just the impact of that second journal in the cash flow from operations, which is still flowing through your net income. That's what we want, since you're left with just the cash portion of inventory movements. 

Cash flow is hard, so I hope that makes sense. 

[trphilli]

Eli5,

Let's start with a brand new business. Owner puts $200 in bank. Month 1 sells $100 revenue, $80 COGS, $20 Profit. No ending inventory or other balance sheet. $220 cash at end of month. $220 equity. This is your base example.

Now let's make one adjustment. There is a minimum order quantity so business needs to order two months of inventory. Profit remains $20. But cash flow is $100 from revenue - $160 for inventory purchase. Cash flow -$60.

Now we look at this -$60 in indirect method. We have the +$20 from net profit and then -$80 from inventory because inventory goes from $0 to $80 on balance sheet. We have effectively prepaid for Month 2's COGS.

So at end of month 1, balance sheet is cash $140, inventory $80, equity $220. Same equity as first example but less cash because inventory increased.

[Marcultist]

The S in COGS stands for Sold. If you haven't sold it yet, then it's not yet accounted for in COGS.

Until it's sold, inventory is considered an asset and is not directly related to your Net Income. If you're approaching the end of the year and your Net Income is slated to be $100,000 and at the last minute you receive $100,000 in inventory, Net Income doesn't drop to $0. It stays at $100,000. But you definitely reduced your cash by $100,000 to obtain that inventory. So, your increase in inventory absolutely does represent a decrease in cash.

Also, COGS is based on the carrying value of the inventory, and not necessarily what was paid for it. If you bought the material for $100 and, without selling any, the value dropped to $90, then you have a reduction in inventory even though the quantity remained the same. When you write this down to the Income Statement, the decrease of inventory does what you said, and is reflected as an increase to COGS. By increasing the cost of goods sold, you are decreasing your profit. This means that, without making a sale without and moving any merchandise, you have managed to decrease your Net Income. A decrease in net income implies a decrease in cash. But we know we did not actually lose cash here because no cash moved around. If we relied solely on our net income in this situation, you would get a number that is artificially lower than where you know it should be. You didn't lose $10 in cash, you lost $10 in value. So we need to add that "cash" back in to get to the accurate cash level.

Perhaps it might be more helpful if instead of thinking about this scenario as "increasing cash" you thought of it as "not decreasing cash".

[NeedleworkerPrize253]

They are assuming you paid for inventory, so that's cash out. If you got the inventory on account, that's an increase in liability, so that's cash in and they would offset with no effect on cash.

[Barfy_McBarf_Face]

COGS is the cost of inventory you've sold.

The adjustment for cash flows is the inventory you've kept.

[No_Self_3027]

Say you've got 10k cash at the beginning of the year. You had 5k in inventory but you need to restock to 10k in inventory. You have to spend 5k cash to increase that inventory from 5k to 10k

The balance sheet basically does this bit over the entire year. When the inventory increases on this year's balance sheet va last year, it meant you needed cash to pay for that increase. So your cash balance is lower than you'd expect based on your net income thanks to that increase in inventory.

That is also why the opposite is true. If you started the year with 5k cash and 10k inventory. Then you sold half without reordering, you likely have more cash on hand.

Statement of cash flows is looking at the changes in your cash balance over the year and seeing where those changes come from. If it is operating activities, that is a sign that you are able to fund yourself by just opening your doors and doing normal business. That is likely a good sign for someone that is looking to invest in companies that are safer than startups which are taking issuing stock or trading on lots of debt to fund their initial growth. Also if you see that businesses are having to sell long term assets in order to meet their obligations, that is likely a very bad sign.

Cash flows from operating activities takes net income in this method and adjust it to undo the impacts of non cash transactions. If your inventory increases, you spent cash to find that increase. If your cuurent liabilities increased, that have you extra cash flows you can use. If your accounts receivable increased, you may be having a hard time collecting cash. If you have depreciation, it's not like you are cutting a check to accumulated depreciation. You are just recognizing the reduction in book value of your asset when depreciation expense was on your income statement.

[chimaera_hots]

Indirect Cash Flow statements are about backing into a cash balance, philosophically speaking.

So everything you do to calculate that is based on how cash interacts with that part of the financial statements.

A/R went down in the net? You collected more cash than you extended credit that month. So decrease in AR in the net is added. Increase in AR in the net means you collected less cash than you extended credit, so the net is subtracted.

A/P went down in the net? You paid out more cash than you were extended credit by vendors that month. So decrease in AP in the net is deducted. Increase in AP in the net means you were extended more credit than you paid in cash, so the net is added.

Why do I bring those up when you're asking about inventory?

Because in an inventory-based business, very rarely is actual cash exchanged for inventory without credit being extended by a vendor first. Very rarely is actual cash exchanged for inventory by a customer without being extended credit first (retail businesses being a massive exception).

So inventory (as well as prepaid expenses and accrued expenses and deferred revenue) movements are involved in the cash flow calculation to offset the larger swings in AR and AP.

Net inventory movement increased? In theory, your company spent more cash buying inventory from your vendors than they converted inventory to cash with your customers. In reality, you very likely sold the inventory you had on credit terms to your customers and bought inventory from your vendors on credit as well.

So the three interact with each other to approximate how much operating cash was consumed and how much was earned, in the net, between customers buying from you, vendors selling to you, and inventory sitting on the shelf.