It is widely understood that the best way to measure a firm’s ability to continue as a going concern is through its financial statements. All investors, creditors, or any other interested parties need this information to make relevant, financial decisions. Although interested parties tend to look at a firm’s net income, the statement of cash flows gives a better measurement of a firm’s financial standing because it deals with cash within a firm.
The following information will reveal why net cash flows are more reliable than net income.
Cash is king and it determines the sustainability of a firm. Since investors and interested parties are concerned about an entity’s ability to generate future cash flows and bring high returns on investments, it is normal to see why they would focus on the firm’s net income. A high net income should indicate high earnings per share (EPS). But does net income show the available cash on hand? What about the net income derived from a firm that uses the accrual basis for accounting? The accrual basis of accounting allows a firm to match revenues and expenses when a transaction occurs rather than when cash is paid or received. Since some of these transactions are on an account, the actual cash payment/receipt has not occurred. The same principle applies to expenses.
Take the depreciation expense, for example, this is not an actual cash transaction. Once broken down, one may see the importance of the statement of cash flows and see why they are more beneficial than a firm’s net income. The statement of cash flows is presented in three categories: cash flows from operating activities, investing activities, and financing activities. Each category determines how much cash is used or provided in the firm. In terms of importance, the source of cash from operating activities is the best measure of a firm’s ability to generate enough cash to continue as a going concern. Operating activities is important because it uses the same information as the income statement and current assets to show the cash transactions within operations. It reflects the firm’s ability to generate cash while showing actual cash payments in regards to relative, day-to-day operations.
Cash flows from investing and financing activities does not necessarily reflect how a firm performs in its industry, but it shows the other uses of cash. Cash flows from investing activities reflect the firm’s use of cash in making/collecting loans and acquiring/disposing of long-term assets. Cash flows from financing activities deal with the firm’s liabilities and owners’ equity. It reflects the firm’s use of cash by obtaining/repaying loans to creditors, and obtaining/providing returns on investments to the owners. Since the statement of cash flows deal with the actual use (not estimates) of cash within a firm, it is much harder to manipulate the numbers. Net income, however, is easier to manipulate because it uses noncash transactions, including depreciation expenses, amortizations, gains/losses on the sale of assets, etc.
If a firm wanted to show a higher net income, thus driving up their EPS, they can easily manipulate the numbers to do so. Take sales on account, for example, if a firm makes a large number of sales on account during a period, the numbers will be reflected in their income statement. The high number of sales will raise the firm’s net income, which also drives up their EPS. An informed investor will look at these numbers and make financial decisions based on the information. On paper, everything looks good, but what if the firm was having difficulty collecting their accounts receivable? The firm would not have enough cash thus, making it difficult for the firm to reinvest, pay obligations, or even pay dividends to the shareholders.
In conclusion, the net income should not be the only factor for making financial decisions. On the downside, the statement of cash flows is not completely flawless, it’s just harder to manipulate. A firm that has difficulty collecting from their customers could sell their receivables for cash thus, generating cash in the business. But for the most part, the statement of cash flows will give a better measurement of a firm’s performance. To simply put it, if an interested party wanted to invest in a publicly-traded firm, and they could only choose one financial statement, the statement of cash flows would be the best choice. In other words, the statement of cash flows is prepared by using information from the income statement and the balance sheet in terms of cash. It provides enough information to make an informed, financial decision.