Question

1) Explain the following statement: “While the balance sheet can be thought of as a snapshot of the firm’s financial position at a point in time, the income statement reports on operations over a period of time.”

2) Differentiate between accounting profit and net cash flow. Why do those two numbers differ?

3) Would it be possible for a company to report negative free cash flow and still be highly valued by investors; that is, could a negative free cash flow ever be a good thing in the eyes of investors?

Answer 1

1. The financial position of an organization on a particular date is being reflected by the balance sheet. The organizational ending account balances of assets and liabilities are mainly being reflected at the end of a financial year through the balance sheet. It also provides information about shareholders’ equity at a particular point in time like at the end of a financial year. Income statement mainly provides information with respect to organizational operations over a period of time such as over one year. It provides insights about revenues and expenses of an entity as well as on its profitability over a financial accounting period.

2. “Accounting profit” is that profit which is determined by the income statement of an organization while “net cash flow” refers to cash income after deduction of cash expenses of an organization. The difference between the two is mainly due to method of accounting followed. Accrual accounting method is mainly followed in the determination of “accounting profit” while cash basis of accounting is followed while determining “net cash flows” for an organization. There are expenses which are included in the computation of “accounting profit” while no cash payments are made in this regard leading to differences between the two. Moreover, costs incurred with respect to prepaid expenses are treated as current assets in accrual method of accounting while they are treated as cash expenses in the cash accounting method leading to differences between “accounting profit” and “net cash flows”.

3. Negative free cash flow is not considered as necessarily bad for an organization. The fastest growing businesses have negative free cash flows because the level of working capital and fixed assets that are needed to sustain rapid growth usually outweigh the cash flows from current operations. This is not termed as bad, as long as the new investments lead to success in the future and contribute to free cash flows of an organization. Hence, it is considered possible for an organization to report negative free cash flow and still be highly valued by investors.