Introduction

RECALL THE STRUCTURE of the income statement: The final measure of profitability after the deduction of all expenses is net income.

Net income is an extremely useful metric in financial analysis; it reflects ongoing profitability. However, since the income statement measures profitability using accrual accounting, it suffers from the limitation of not being able to objectively tell us what is happening to cash during the year.

The Lemonade Stand—Revisited

You purchased a lemon squeezer and a lemonade stand for $30 and estimated that both of these fixed assets will have a useful life of three years, by the end of which they will be obsolete and be thrown away.

It is important to recall that even though you paid cash upfront for the entire cost of the machine, you did not expense the entire $30 cost on the income statement. Instead, you estimated a useful life of the squeezer for generating lemonade (i.e., revenues for your business) to be three years, and so you spread the depreciation expense (at $10 per year) over this period in order to match revenues and expenses, as required by the accrual accounting.

January 1, 2007 to December 31, 2007 Income Statement
Revenues100
– Cost of Goods Sold20
– SG&A15
– D&A10
EBIT55
– Interest Expense5
– Taxes20
Net Income30


Year 1

  • D&A expense was $10 (as shown on the right)

  • Actual cash expense was $30

Year 2

  • D&A expense is $10

  • Cash expense is $0–you already paid for the machine in year 1

Year 3

  • D&A expense is $10

  • Cash expense is $0

 Year 1Year 2Year 3
Cash$30——
D&A$10$10$10


Clearly the cash flowing out of the company does not equal the expenses that the company has recorded on the income statement.

Also recall the example in Chapter 6 in which you sold some lemonade on credit. You recorded the sale as revenues on the income statement, even though you didn’t actually receive cash income from the transaction until some time later.

It should be clear by now that the income statement, which by virtue of employing the accrual method of accounting (which is quite helpful in many respects), has by definition the limitation of not being able to show us exactly what is happening to a company’s cash flows for that specific accounting period.

Why is tracking a company’s cash flows important? Let’s imagine two opposite scenarios:

  • Scenario 1

    • Company A shows a very profitable income statement, but is losing cash. You would definitely want to analyze why, particularly if that company has few cash reserves, but has a large amount of debt outstanding that it must repay to its lenders in the near future, but may be unable to do so.

    • Possible reason: The company may be selling more products on credit.

  • Scenario 2

    • Company B shows negative profitability, but is accumulating a very large amount of cash. What is the source of that cash and is it sustainable at current levels?

    • Possible reason: Suppliers have eased payment terms or the company has reduced purchases of fixed assets abruptly.

The cash flow statement has been created to facilitate trace analysis of a company’s cash flows.

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