Question

Review the existing literature to critically examine the relative information content of the income statement and the statement of cash flows. Why do investors find both income statement and statement of cash flows useful?

Answer 1

An Income statement is an important financial statement prepared by firms which depicts net profit or loss earned during the period. The following are the information contents of Income statement

· It shows the various types of revenue earned by the firm. For example: Sales revenue, service revenue, dividend income, interest income etc

· It shows the various types of expenses incurred by firm. For example : Cost of goods sold, operating expenses like selling, general and administrative expenses

· It shows the non cash expense and gains incurred and earned by firm. For example : loss on sale of assets, gain on sale of investments,

· It shows extraordinary losses and gains. For example : loss due to earthquake, restructuring expenses, etc

· It shows the income tax expense of the firm

· It finally shows the net income or loss earned by firm and Earning per share.

Income statement is useful to investors due to the following reasons:

· It helps in ascertaining net income or loss earned by the firm during a particular period

· It helps in understanding the profitablity ratios of the firm. For example : Gross profit, net profit margin,

· It helps in understanding the cost incurred and its movement. For example: Cost of goods sold ratio , operating expense ratio, etc

· It helps in calculating important ratios like times interest earned. It is calculated dividing Operating income by Interest expense

· It helps in understanding Earning per share during the period. Earnings per share is calculated based on Net income available to equity shareholders dividend by average number of common shares during the period

· It helps the stockholders in understanding the profitablity of their investment through Return on equity

· It helps in deciding how much dividend should be paid to the stockholders at the end of the period

A Statement of cash flows is also an important part of financial statements issued by the firm which gives details of cash and its movement during the year. The statement of cash flows has gained lot of importance now a days since Income statement is prepared on accrual basis which does not show the cash flows of an organisation

Contents of Cash flow statement

· Cash flow from operating activities – This gives the details of cash flows earned by the firm during the year from core operating activities. The cash flow from operating activities is calculated by adjusting net income for non cash expenses and gains and then adjusting for operating current assets and liabilities movement

· Cash flow from investing activities – This gives the details of cash flows from investments and fixed assets of the firm. For example : cash received from sale of assets and investments, cash purchase of fixed assets and investments, etc

· Cash flow from financing activities- This gives the details of cash flows from financing related activities. For example: Issue of bonds payable, Issue of common shares , Repayment of borrowing, payment of cash dividend, etc

· Non cash investing and financing activities- This gives the non cash related activities which have material impact in understanding financial statements. For example : purchase of land through issue of common shares, conversion of debt to equity, etc

A Statement of cash flows is useful to investors due to following reasons:

· It helps in understanding movement of cash and cash equivalents during the year

· It helps in understanding whether core operating activities of the firm is generating cash or not for the business

· It helps in understanding whether cash is generated from operating current assets and current liabilities.

· It helps in understanding free cash flows generated in business. Free cash flows is cash flow from operating activities minus capital expenditure

· It helps in managing finance at overall firm level and ensuring smooth running of the business.

· It helps in financing activities of the firm and takes right decision regarding raising funds for the firm.

· It helps in understanding how debt is managed by the firm. For example : Borrowing and repayment of loans, etc,

· It helps in calculating various ratios for example: Cash flow from operating activities to current liabilities. Cash flow from operating activities to capital expenditure, etc