Question

Companies file for bankruptcy protection more often than not due to cash problems. We know from studying accrual accounting that profits and cash flow most often have different timing. Comment on how the income statement and the cash flow statement are connected. Do you feel both statements provide sufficient information for internal managers and external investors to make good decisions? Provide support for your response?

Answer 1

The income statement and cash flow statement is connected to a great extent. The following points would prove the interconnection:

1. There is an indirect method to prepare the cash flow statement which takes with the net profits from the income statement as a starting point. This proves there is a direct connection.

2. The income statements lists out the revenue from sales, expenses incurred during the current reporting period. A part of these revenues and expenses may be deferred or in advance which will make the cash flow from operations differ a bit from the income statement, but the same will be received or paid sooner or later. It is more of a timing difference w.r.t. accrual v/s payment.

3. Further the investment and financing part of Cash flow statement is also interrelated. Say a new machinery is acquired (impacts cash flow from investment) will need substantial financing (impacts cash flow from financing) but will result in increase in production and then revenue will end up increasing revenue on income statement and the cash generated from this revenue will flow back on cash flow statement (impacts cash flow from operations). Hence it flows in a cycle!

Both the statements combined provide a great deal of information to the investors. Income statement provided the performance of the company in terms of increase/decrease in sales, increase/decrease in cost, increase/decrease in other figures impacting the company performance and then finally the net results increase/decrease as compare to last year. They provide great metrics Again just an increase in sales in itself is not sufficient, the sales should be realisable and result in an increase in the cash flow of the organisation. Hence where is the cash flow is improving it speak well about the company performance. However, where sales is increasing but not the cash flow, speaks about the operation inefficiency and gives lot of information to the investors. Again investments in new plant and machinery or new acquisition will be evident from investment activity under cash flow statement. Hence both these statements provide great deal of information to the investors along with the sources of financing.

However, both these statements might not be completely sufficient as they provide only historic information and might not detail all the facts, which might be a matter of concern for the users of information. For eg: Further expansion plans, change of line of operations, company expecting losing out on a major litigation, huge tax/penalty demands being contested, usage of redundant technology, etc.