By Chron Contributor Updated September 21, 2020
Small businesses may have losses in the first year or two of operations because it takes time to establish a market presence and generate enough revenues to cover costs. A loss does not necessarily mean an example of negative cash flow, just as a profit does not always mean a positive cash flow. This is due to accrual accounting rules, which require companies to record transactions in the period they occur, not when they receive or pay cash.
Definitions and Basics
Net income is sales minus expenses, which include cost of goods sold, general and administrative expenses, interest and taxes. The net income becomes negative, meaning it is a loss, when expenses exceed sales, according to Investing Answers. Total cash flow is the sum of operating, investing and financing cash flows. Operating cash flow is usually different from net income because of adjustments for non-cash transactions. Investing cash flow usually consists of fixed asset transactions, such as the acquisition or sale of a manufacturing facility. Financing cash flow involves proceeds from sale or purchase of equity and debt securities.
Example 1: Depreciation
Depreciation is the periodic allocation of a fixed asset's costs over its useful life, which is substantially longer than a year. A common depreciation method is the straight-line method, in which the annual depreciation expense is the same each year. The depreciation accounting entries are to debit depreciation expense and credit accumulated depreciation, which reduces the book value of fixed assets on the balance sheet.
For example, if a small business has a $5,000 computer on its books, the annual depreciation expense over its estimated five-year useful life is $5,000 divided by 5, or $1,000. This expense will reduce net income, but it will be added back to operating cash flow because it is a non-cash expense. Therefore, while net income could be negative, the cash flow would show a gain.
Example 2: Accrued Expenses
Accrued expenses are expenses that have been recorded but have not been paid, such as salaries and interest expenses. For example, if a company makes direct deposits on day 15 of each month, it would have about two weeks' worth of wages accrued but unpaid at the end of the year. If this amount is $5,000, the accounting entries are to debit wages expense and credit wages payable by $5,000 each. This would reduce net income for the current year, possibly turning it negative, but the cash flow may still be positive because the wages payable amount is added back to the current year's operating cash flow, according to Accounting Coach.
Other Considerations
A negative net income could mean a lower tax expense this year and the possibility of applying the loss to reduce taxes in subsequent years. However, losses may not result in positive cash flows every year, because these losses may be too high for them to be offset by non-cash adjustments. Companies with negative cash flow do exist; examples of negative cash flow are usually geared around companies who are investing in research and development or other future endeavors.
Debits increase asset and expense accounts, and decrease revenue, liability and shareholders' equity accounts. Credits decrease asset and expense accounts, and increase revenue, liability and shareholders' equity accounts.
FAQs
Small businesses may have losses in the first year or two of operations because it takes time to establish a market presence and generate enough revenues to cover costs.
Can a company have negative net income and positive cash flow? ›
If a company sells an asset or a portion of the company to raise capital, the proceeds from the sale would be an addition to cash for the period. As a result, a company could have a net loss while recording positive cash flow from the sale of the asset if the asset's value exceeded the loss for the period.
What is an example of a negative revenue? ›
A negative revenue figure may mean that you had to credit a customer or customers for more than you sold in a given period. Example: In January, you recorded $10,000 in revenue (this would show up as a positive figure, as it should). In February, you bill $4,000 in services to Client B.
What happens if net income is negative? ›
Negative net income means the company has incurred more expenses than its revenue, resulting in a loss. A negative net income can indicate that the company is struggling financially and may be unable to cover its obligations.
Do most businesses lose money the first year? ›
Most businesses don't make any profit in their first year of business, according to Forbes. In fact, most new businesses need 18 to 24 months to reach profitability. And then there's the reality that 25 percent of new businesses fail in their first year, according to the Small Business Administration.
What is an example of a negative cash flow? ›
Negative cash flow is when your business has more outgoing than incoming money. You cannot cover your expenses from sales alone. Instead, you need money from investments and financing to make up the difference. For example, if you had $5,000 in revenue and $10,000 in expenses in April, you had negative cash flow.
Can a company have negative cash flow and still be profitable? ›
Yes, a profitable company can have negative cash flow. Negative cash flow is not necessarily a bad thing, as long as it's not chronic or long-term. A single quarter of negative cash flow may mean an unusual expense or a delay in receipts for that period. Or, it could mean an investment in the company's future growth.
Can a firm have negative cash flow and still be financially healthy? ›
A business could make net profit while having negative cash flow. Earning revenue does not necessarily mean that the company has received cash immediately. The actual movement of cash may happen later. For instance, a company sold goods and accrued profit on the income statement but did not receive the money yet.
Can a company operate with negative net income? ›
Yes. If the calculation of net income is a negative amount, it's called a net loss. The net loss may be shown on an income statement (profit and loss statement) with a minus sign or shown in parentheses. A company with positive net income is more likely to have financial health than a company with negative net income.
Why would a company have negative revenue? ›
If revenue is negative, the company may have lost money during operations or the tag may be incorrect. This issue tends to surface when someone is doing a massive dive into the data – looking at thousands of companies at a time without consideration of the industry the company is in.
A firm can have negative earnings because of inefficient operations. For instance, the firm's plant and equipment may be obsolete or its workforce may be poorly trained. The negative earnings may also reflect poor decisions made in the past by management and the continuing costs associated with such decisions.
What is negative income in business? ›
Negative income occurs when the operating expenses are higher than the gross receipts (or revenue) of a self-employed person, business or a rental property.
Is a negative net income good or bad? ›
This indicates that, on paper, the company is losing money. Creditors often view negative net income as a red flag. It tells them that a business may struggle to meet its debt obligations.
What is an example of loss of income? ›
For example, say you're a construction worker earning $1,000 weekly. If you missed eight weeks of work due to an injury, your loss of income would be $8,000. This amount is generally easy to verify with pay stubs, employment records, or bank statements.
Is negative net income always bad? ›
If net income is consistently negative due to no good reasons, then that is a cause for concern. New businesses, such as startups, typically have many years of losses before becoming profitable, making return on equity a poor measure of their success and growth potential.
Why do most businesses fail in their first year? ›
The most common reasons small businesses fail include a lack of capital or funding, retaining an inadequate management team, a faulty infrastructure or business model, and unsuccessful marketing initiatives.
Why do most small businesses fail in the first year? ›
A primary reason why small businesses fail is a lack of funding or working capital, according to Mr Mooney. Running out of money is a small business's biggest risk. Owners often know what funds are needed from day to day but are unclear as to how much revenue is being generated, leading to poor cash flow management.
Why do companies have negative net worth? ›
Deficit net worth is a situation in which a person or a company's liabilities are greater than their assets. Also known as negative net worth, deficit net worth can occur for a variety of reasons, but it typically arises when current or future asset values erode unexpectedly.
What is the reason for negative net profit? ›
A negative profit margin is when your production costs are more than your total revenue for a specific period. This means that you're spending more money than you're making, which is not a sustainable business model. Many companies have negative profit margins depending on external factors or unexpected expenses.
