Question

2) Why may it be difficult to rely on profits to get an overall impression of the firm’s cash flows?

Answer 1

It is not advisable to conclude profit as cash flow of the firm.

Profit is doesn’t reflect exact cash flow position. Profit statement is arrived after considering cash and not cash items. Non-cash items are not actually cash expenses. There are few example of non-cash items; Depreciation and writing off intangible assets. On this non-cash items, we gain tax shield or tax benefits and which enhances the net cash flows of the firm. In general, we can say the profit is wider than the cash flow. Computed profit will always be lesser than Cash flow derived from same set of information.

Firm’s cash flows are pretty straight forward in calculation, we arrive at net cash flow by summing up the total inflow minus total outflow.

If we are deriving cash flow from profit statement then we should add back the non-cash items in profit figure so that we can arrive at appropriate yearly cash flow.

Hence, it is difficult to rely on profit statement for concluding cash flow of the firm.