Question

why is the income statement a poor gauge of cash flow and how does the cash flow statement address this problem with the income statement?

Answer 1

Income statement is a poor gauge of cash flow because it does not reflect the net cash inflows and outflows. Basically, income statement are prepared on accrual basis and it takes all incomes and expenses on accural basis. It takes the effect of outstanding expenses and prepaid expenses which has been occured in the last year. So, it does not show the actual cash outflows and inflows only for the current year. A part from it, income statement also takes non cash expenditure e.g. depreciation which has nothing to do with cash flow.

Cash flow statement is different from income statement. It is prepared on cash basis and takes all cash outflows and inflows. All activities of cashflows are cateogrised in three parts in cashflow statement which are Operating activities,investing activities and financing activities.With the help of cash flow statement, we come to know the actual increase or decrease in cash in a particular year.