Question

Answers should be substantive and include consideration of relevant accounting concepts.

What is the usefulness of the statement of cash flow? Do the balance sheet and income statement provide sufficient cash flow information?

Answer 1

The cash flow report is important because it informs the reader of the business cash position. For a business to be successful, it must have sufficient cash at all times. It needs cash to pay its expenses, to pay bank loans, to pay taxes, and to purchase new assets. In addition, management uses cash flow for the following:

• To determine problems with a company’s liquidity
• To determine a project’s rate of return or value
• To determine the timeliness of cash flows into and out of projects, which are used as inputs in financial models such as internal rate of return and net present value

Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash even when it is profitable. Cash flow is often used as an alternative measure of a company’s profitability when it is believed that accrual accounting concepts do not represent economic realities.

The balance sheet and income statement do not provide sufficient cash flow information. The balance sheet only giving the final balance of cash, not the breakdown of cash flow which will help to find out free cash flow. The income statement includes expenses like depreciation which has no cash flow. Depreciation is not a relevant cash flow for investment appraisal.

For investment appraisal, only the relevant cash flow is only considered. Relevant cash flow is the future, incremental, and which have cash flow. It will only get from the cash flow statement.