Why is a Statement of Cash Flows needed?

Answer 1

NEED FOR A STATEMENT OF CASH FLOWS

A profitable firm may run out of cash because of the relationship between cash and income which are described as follows.

1 . Net income for a particular period does not equal cash flow from operations. Most firms use the accrual basis of accounting to measure operating performance. For example, firms typically recognize revenue at the time of sale, independent of when they receive the cash from the sale. Some firms, such as airlines and insurance companies, receive cash before providing services and recognizing revenues. Others, such as manufacturers and distributors, receive cash after they have provided goods and recognized revenues. Thus, revenues on the income statement for any period will not likely equal cash received from customers for that period. As another example, firms recognize expenses either in the period when they recognize associated revenues or in the period when they consume materials or services in operations. The cash outflow related to a specific expense need not occur in the period when the firm recognizes the expense, so expenses on the income statement for any period will not likely equal cash paid to suppliers of materials and services for that period.

Most of the cash outflows for expenses occur before the firm receives the cash inflows from a sale. This lag between cash outflows and cash inflows can lead to cash shortfalls, particularly for a growing firm. Consider the typical firm where cash disbursements to employees and suppliers precede cash collections from customers. The faster such a firm grows, the greater is the shortfall in cash. In this setting,the firm must take steps to obtain the funds necessary to pay suppliers while it awaits cash collections from its own customers; for example, the firm might borrow funds from the bank on a revolving credit arrangement.

The preceding examples highlight the fact that, for any accounting period, the income statement usually will not reflect the cash flows for the period. Stated differently, using the accrual basis of accounting to measure net income creates the need for a separate financial statement that reports the impact of operations on cash flows. That statement helps the reader judge a firm's cash flow needs and how it has dealt with them.

2 . Firms receive cash inflows and disburse cash outflows because of investing and financing activities, which the income statement does not report directly. Firms building their productive capacity generally use cash to acquire property, plant, and equipment. Short- and long-term borrowing comes due, requiring cash. Firms that regularly pay dividends to shareholders are reluctant to curtail the dividends when cash is tight. None of these transactions affects the income statement in the period they occur. For example, the firm capitalizes (that is, records an asset, not an expense) its expenditures for property, plant, equipment, and purchased intellectual property in the period of acquisition. Later periods' income statements will reflect the expensing of these costs, as depreciation or amortization. Firms use cash for debt service payments. Some of those payments are for interest expense, which the income statement will report. The remainder discharges obligations for principal repayments and is not expense, so it never appears on an income statement. Firms use cash also to pay dividends, which are not expenses reported on the income statement, although they do reduce retained earnings. Dividends are distributions of net assets to owners. These examples highlight how a profitable firm can collect more cash from customers than it pays for current-period expenditures and still have cash shortages.

Neither the balance sheet nor the income statement displays the firm's sources and uses of cash. The balance sheet reports the balance in cash at the beginning and end of the year but does not explain how cash changed during the period. The income statement measures the increase (or decrease) in net assets from selling goods and services for more (or less) than their costs. Accrual accounting results in an increase in net assets, but seldom all in cash, when the firm earns income. The statement of cash flows helps a reader understand how a firm obtains and uses cash.