The statement of cash flows provides information that helps the reader in (1) assessing the impact of operations on liquidity and (2) assessing the relations among cash flows from operating, investing, and financing activities. Explain

Answer 1

USING INFORMATION FROM THE STATEMENT
OF CASH FLOWS

The statement of cash flows provides information that helps the reader in (1) assessing the impact of operations on liquidity and (2) assessing the relations among cash flows from operating, investing, and financing activities.

IMPACT OF OPERATIONS ON LIQUIDITY

Perhaps the most important omission from the balance sheet and the income statement is how the operations of a period affected cash flows. Increased earnings do not always generate increased cash flow from operations. When increased earnings result from expanding
operations (that is, more units sold in contrast to increases in selling price or reductions in cost), the firm usually has decreased cash flow from operations. A growing, successful firm may have increasing amounts for accounts receivable and inventories, resulting in a lag between earnings and cash flows.

The need to await the collection of accounts receivable but to acquire and pay for additional inventory in anticipation of greater future sales can lead to negative cash from operations. Growing businesses use financing from long-term debt issues or common shares issues to cover short-term cash needs. A failure to obtain long-term financing can lead to chronic liquidity problems.

On the other hand, increased cash flow can accompany reduced earnings. Although such a firm likely will report reduced net income or even losses, it might experience positive cash flow from operations. The positive cash flow results from its collecting accounts receivable from prior periods while it does not replace inventories, thus saving cash.

RELATIONS AMONG CASH FLOWS FROM OPERATING,
INVESTING, AND FINANCING ACTIVITIES

The relations among the cash flows from each of the three principal business activities differ depending on the characteristics of the firm's products and the maturity of its industry.

A new, rapidly growing firm. It is not yet profitable, and it experiences buildups of its accounts receivable and inventories. Thus, it has negative cash flow from operations. To sustain its growth, the firm invests heavily in plant and equipment, and it relies on external sources of cash to finance both its operating and its investing activities.

A somewhat more seasoned firm than the previous one, but one that
is still growing operates profitably and generates positive cash flow from operations. This cash flow from operations, however, falls short of the amount the firm needs to finance acquisitions of plant and equipment. The firm therefore requires external financing.

The a mature, stable firm generates sufficient cash flow from operations to acquire new plant and equipment and to repay financing from earlier periods and, perhaps, to pay dividends.

A firm in the early stages of decline has cash from operations that has begun to decrease but remains positive because of decreases in accounts receivable and inventories. In the later stages of decline, its cash flow from operations may turn negative as it finds itself
unable to sell its products at a positive net cash flow. It cuts back significantly on capital expenditures because it is in a declining industry. It uses some of its excess cash flow to retire outstanding debt and shares, and has the remainder available for investment in new products or other industries.