Discuss the relation between net income and cash flow from operations when interpreting the statement of cash flows
INTERPRETING THE STATEMENT OF CASH FLOWS
RELATION BETWEEN NET INCOME AND CASH FLOW FROM OPERATIONS
Net income (Revenues minus Expenses) differs from Cash Flow from Operations (Receipts from operations Expenditures for operations). The balance sheet reflects these differences in the changes in current and noncurrent accounts:
1 . Changes in noncurrent assets and noncurrent liabilities.
2 . Changes in operating working capital accounts.
Changes in Noncurrent Assets and Noncurrent Liabilities
The extent to which a firm adjusts net income for changes in noncurrent assets and noncurrent liabilities in deriving cash flow from operations depends on the nature of its operations. Capital-intensive firms will likely show a substantial addback to net income for depreciation expense, whereas service firms will show a smaller amount. Rapidly growing firms usually show an addback for deferred tax expense, whereas firms that stop growing or that shrink show a subtraction. Firms that grow or diversify by acquiring minority ownership positions in other businesses will often show a subtraction from net income for equity in undistributed earnings. Firms that decrease in size will usually show additions or subtractions for losses and gains on the disposal of assets.
Changes in Operating Working Capital Accounts
The adjustment for changes in operating working capital accounts depends in part on a firm's rate of growth. Rapidly growing firms usually experience significant increases in accounts receivable and inventories. Some firms use suppliers or other creditors to finance these working capital needs (classified as operating activities), whereas other firms use short- or long-term borrowing or equity financing (classified as financing activities).
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