Question

Class, does this mean that the income statement--with it's emphasis on the correct determination of net income--is less meaningful than the information found on the cash flow statement? Share your opinions here everyone, and support your views.

Answer 1

Both net income and net cash flow are equally important while analysing financial statements. A firm should manage its cash flow along with net income. Net cash flow is important from liquidity and solvency point of view since organisation would need cash to pay its vendors, employees, and operating expenses and meet its financing requirements like purchase of fixed assets, investments. Income statement helps in understanding operating profit or loss and net income or loss during the period. It helps in understanding the profitablity of the business like gross margin, operating margin and net margin. It also helps in computing Earnings per share and dividends that can be given to shareholders. Income statement also helps in analysing and interpreting few important ratios like accounts receivable turnover, inventory turnover, times interest paid, Return on assets and Return on Shareholders’ equity.

Income statement is also required for external reporting and it should be prepared in accordance with GAAP. Income statement is prepared on accrual basis concept hence it would have income and expenses which do not have actual cash inflow or outflow for example: service performed on credit basis, depreciation expenses, gain or loss on sale of assets and investments, etc. Hence Income statement does not give an idea of cash flows during the year. To overcome this drawback of Income Statement, cash flow statement is prepared since it helps users in understating how cash movements happen during the year. A highly profitable company may have poor cash flows if it does not manage its current assets and current liabilities in a proper way. Hence a cash flow statement is important for understanding cash flow movements during the year.