Income and Cash Flow Statements

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Introduction

According to Almeida, the balance sheet, income statement, and cash flow statements are the universally known financial statements used by most businesses and practitioners for financial reporting purposes. Although the same financial data is used while preparing the statements, the eventual computation will each be used to analyze different aspects of the organization in question. The cash flow statement when used with other statements asseses the ability of an entity to generate and use cash over a certain period. The income statement alternatively measures a company’s financial performance in a given financial period. Similarly the balance sheet is a quick glance revealing the company’s financial resources and financial obligations in a certain pont in the life of the company (2004: 35).

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Financial reporting using the two statements is a requirement of every company according to the International Accounting Standard 7, which was previously mandated by Financial Accounting Standards Board Statement No. 95 (FAS 95). However in some counties cash flow statement preparation is not included in the Companies Act. As a result, it is expected of all public limited companies that are registered and trade shares in the stock exchange market in accordance to other statutory regulations and laws (Myers & Majluf 1984: 145).

In effect, financial statements have been used for important decision-making that affect the future operation of the company in question. Examples include decisions on re-investing profits or widening the company’s operations. Management on the other hand receive the analyzed and interpreted financial statements ready for presentation to the shareholders during annual meetings, and whenever the need arises to do so. Collective bargaining agreements are tools that employees use when presenting their requests to the management. Many a times, instances for salary increases or improvement of working conditions require information contained in the financial statements for each party to attest to the final decision thereof. Other users of the financial statements include banks and non-bank financial institutions, prospective investors, government entities, media and the public in general (Gill & Chatton 1999).

Definition of the statements

The income statement

The income statement (“statement of revenue and expense”/”profit and loss statement”) measures the financial performance of a company. This measurement is given in a summary of how the company earns its revenues and incurs its expenses, according to the IAS 1 requirements. The income statement also provides the net profit/loss for a given financial year (Myers & Majluf 1984: 155-156).

According to Bandler (1994: 26), the income statement being one of the three major a financial statements is divided into two parts; operating and non-operating parts. On one hand, the operating section discloses information about revenues and expenses from regular business operations makes it equitably attractive to both investors and analysts. On the other hand, activities that are not directly tied to the company are reported by the non-operating section.

The most typical structure of the income statement is as follows;

  • Revenues

Less: Cost of Good Sold

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  • Gross Margin

Less: Operating Expenses

  • Operating profit

Less: Extraordinary Income/ (Expenses)

Less: Non-operating Income/ (Expenses)

  • Profit before Tax

Less: Corporate Income Tax

  • Net Income

Cash flow statement (CFS)

So as to complement the balance sheet and the income statement in accordance with the 1987 company financial reports standards, a cash flow statement (or sources and uses of funds statement or a statement of changes in financial position) is used to record cash and cash equivalent amounts that enter or leave the company. The CFS therefore provides the information that an investor needs to analyze the company’s operations, sources and uses of its money. A CFS therefore is a tool of analysis for every company reflecting the company’s liquidity or solvency. Although the statements are used to analyze a company’s financial aspects, the difference is that the cash flow statement excludes the amounts of future incoming and outgoing cash recorded on credit. That financial statements are prepared on accrual accounting basis means that the non-cash items are taken into consideration in an effort to accurately portray the financial status of the company. For instance a company reporting a $2 billion earning does not necessarily imply that the amount is in the bank account (Almeida 2004: 57).

According to Diamond (1991: 89) the most common form of cash flow statement has three sections; cash flows from operating activities, cash flows from investing activities and cash flows from financing activities. This 3-level classification is in accordance to the International Accounting Standard No. 7 (IAS 7). In spite of that, other practitioners adopt the four-section format, whereby the supplemental information mainly deals with all the other vital non-cash items. Furthermore the 3 categories each have their own distinct components that vary according to the source and use of funds. For instance cash flows from operating activities reflect the line of the business the company is involved in. This section is composed of cash sale receipts; payroll; payments for employees, tax, suppliers, contractors, monthly rents, and utilities. In other words, this section of the cash flow statement affects items recorded in the income statement by converting their form of recording from accrual basis to cash accounting basis. Secondly the investing activities’ section is made of investments that are not similar in type to the line of business. These cash flows include property purchases; proceeds from plant/equipment, redemption of investments, acquisition of stock/shares, and sale of property. In this investing section, reports mainly focus on the purchase and sale of the long-term investments. Last but not least, the third and most important is the financing activities section. These cash flows result from loan proceeds and debt instruments used by the company for finance. Similarly others include cash from installation, stock/share issuance proceeds, repayments, returns on capital, and repayments on dividends (Dyck & Zingales 2004).

That cash for CFS is both cash (including both cash at hand and demand deposits) and cash equivalents (held for the sole purpose of meeting short-term cash obligations rather than for the purposes of investment); restricts the reporting using this statement to purely cash-based. Therefore these cash equivalents includes short-term, temporary investments readily convertible to cash such as marketable securities, short—term certificates of deposit, treasury bills, and commercial paper (Diamond 1991: 112).

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According to Graham & Meredith (1998) the preparation of cash flow statement has over time been modified to suit the demands of the time it was required. The format that is currently adopted for reporting cash flows from operating activities is either the direct or indirect methods; while cash flows the Gross basis and Net basis is are used while cash flows from investing and financial activities are being reported. However, both methods have been standardized such that the result of both methods using similar company information would result in accurately the same statement. The Direct Method analysis of the cash and bank account identifies cash flows specifically during the period for which the analysis is done. One method involves the use of a detailed general ledger report in place of cash receipts and disbursement journals. Alternatively, cash flows can be determined by preparing a worksheet for each major line item. In order to arrive at the net cash effect for a particular item, there is need to get rid of the effects of accrual basis accounting for the period. The IAS 7 classifies the direct method as detailing on the gross cash receipts and gross cash payments.

The Indirect Method analysis is done on income and expense accounts and working capital. This method usually begins with profit before tax and further compares it with non-cash charges and credits; eventually compared with cash flow from operating activities (Kaplan & Zingales 1997).

Mathematically

Net income per the income statement – entries to income accounts + entries to expense accounts that do not represent cash flows = cash flows before movements in working capital +/- change in working capital. Translated as;

Increase in current assets – the amount of cash spent to acquire the asset means that the change is recorded as a negative figure

Decreases in current assets – due to the amount of cash received from liquefiable assets thus the records are as a positive figure.

Increase in current liabilities – reported as a positive figure (this is because surplus liabilities are an indicator that less cash was spent).

Decrease in current liabilities – due to the cash used to reduce the liabilities, the resulting figure is recorded as a negative. The eventual effect is thus reported as operating activities cash.

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As a matter of fact, there is no difference in the cash flows produced from either the direct method or the direct method; especially when comparing investing and financing activities’ cash flows (Allayannis & Mozumdar 2004).

Cash flow determination takes into consideration three channels through which cash enters and exits the company. These routes include financing, core operations and investing, outlined below;

Operations function

  1. Accounts for cash entering and leaving the company during the core business operations.
  2. Reflects how much cash is generated from a company’s products or services.
  3. Accounts for increases/decreases in cash, accounts receivable, depreciation, inventory and accounts payable.

Investing function

  1. Shows changes in equipment, assets or investments.
  2. In the purchase of new equipment and short-term assets, cash leaves the company. Therefore, these changes are considered “cash out” items. Alternatively, a divestiture of an asset becomes a “cash in” item.

Financing function

  1. Computes increases and/or decreases in loans, debt or dividends.
  2. Calculates capital changes on cash during payment of declared dividends. An example in the day-to-day transaction is the issue of a bond for funding purposes to the publics; which results in the company’s cash increases. On the other hand, payments of interest to bondholders act negatively by reducing cash.

Relevance of the income statement and cash flow statements

While the cash flow statement records the cash movements in cash in an accounting period in addition to the cash that has been recorded on credit, the income statement adheres to the accrual basis accounting. Generally, all cash inflows and outflows are shown in the analysis by both methods. Consequently, there is need to clearly define the difference between cash flow and income. This is because it is not always a guarantee that a business that has positive cash flows is always profitable, and vice versa for a company with negative cash flows experiencing losses. For example a company in the brewery industry that has low demand for its brands opts to sell off some of the manufacturing equipments at throw away prices. This will increase cash in flow as the buyer will be paying for the ‘cheap’ equipment. In the event, the brewery is actually losing in the sale because it would have been preferably profitable to retain the equipment for use to produce drinks that would benefit the company from operating profits. In desperation to survive, the company will sell more of the equipment at prices lower than what was initially paid for. From such an illustration, it is possible to have positive cash flow and negative profitability. Therefore, users of financial statements ought not to analyze a cash flow statement or income statement alone, but should look at a number of them before making any decision based on the financial reports (Hey 2007).

Benefits of financial statements

First, the income statement reports on a company’s revenues and expenses especially to investors and stakeholders concerning the overall performance of the company. Secondly, in checking the ratio of budgeting for over- and under-budgeted sections of the business, small business owner effectively use the income statements. This way certain items that cause unexpected expenses are pointed out. Thirdly, it reports earnings per share (“EPS”) which is the ratio of how much shareholders would earn in form of declared dividends (Bernstein & Wild 1999: 124).

According to Bandler (1994: 67), different stakeholders use the financial statements in different ways. Most of them consider the statements as indicators that determine if their transactions would be viable or not. However, there are principal users of financial statements including investors and lenders. Apart from these two, other users include suppliers, customers, managers, owners and even plaintiffs and their attorneys. Although all of them may be interested in the statements, others place different emphasis on certain components that matter most to them. Therefore each individual or group attaches the same document to a reason that works best to his/her status. While the owners worry about getting a return on their investments; the customers wonder whether the company will still be in business the following day; the managers worry if they are running the company efficiently; the suppliers worry whether there is enough money to pay him; the lenders wonders whether he will be paid back; the current employees wonder whether the company will be able to pay him more; the prospective employees worry if the company has a future; and the attorneys and litigants wonder if the company is worth suing.

Limitations of the financial statements

Evidently, a Cash Flow Statement can be pulled out from the income statement and balance sheet statements. The net earnings figure is also used in the preparation of the cash flow statement. However, the accounting basis of reporting in the income statement disadvantages it against the cash flow statement. This is because there is a possibility that the revenues reported for a given period may not have actually been collected; and neither could the expenses recorded have actually been paid. Such conclusions are deducible when a review of the balance sheet changes is conducted. Therefore, the increased adoption of using cash flow statements by investors and business people is due to the ability of the cash flow statement to integrate the features of both the income statement and balance sheet (ACCA, 2005: 324).

Although the cash flow statement does the work of both the balance sheet and income statement combined, profitability over a certain period of time consists of items that are not always cash-based. Because of this inability to measure profitability, the cash flow statement is not a suitable tool to measure the company’s financial status (Clearly 1999: 673-692).

Many practitioners in their budgeting plans are advised to adopt cash flow prediction is their effort to estimate future cash flows. On the other hand a positive picture through the cash flow is reflected through the cash flow. However, when a company opts for a growth and expansion strategy, a negative cash flow may result. In order to get accurately estimate the amount of cash generated and especially how much of the same is from core operations, an investor is tasked with the responsibility of adjusting the revenues, earnings, assets and liabilities of the company.

Conclusion

This paper analyzes the two mostly adopted financial statements in the companies’ annual financial reporting. The two statements therefore represent the most vital financial reporting compared to the rest of the commonly used statements. The cash flow statement’s ability to account for sources and uses of cash, places it in a higher level compared to the income statement and other statements. Similarly, the income statement is important as it measures the financial performance of a company. These statements both work together to convey certain vital information for creditors, investors and other stakeholders of a given organization. Therefore, a company’s ability to operate, income quality and financial flexibility are depicted to the creditors using these statements. Therefore, an organization presented as credit worthy to the creditors when they are recovering their money. Other users of financial statements including the government and non-governmental bodies can easily assess the company’s feasibility of being tendered.

References

  1. ACCA study Text part 2(2005) Paper 2.5 Financial Reporting, FTC Foulks Lynch, p.324.
  2. Allayannis, G. & Mozumdar, A. (2004) ”The Impact of Negative Cash Flow and Influential Observations on Investment-Cash Flow Estimates,” Journal of Banking and Finance 28
  3. Almeida, E., Campello, M. & Weisbach, M. S. (2004), ”The Cash Flow Sensitivity of Cash”. Journal of Finance 59. Pg, 37-57
  4. American Association of Public Accountants, American Institute of Certified Public Accountants. (1915) Journal of accountancy. American Institute of Certified Public
  5. Bandler, J. (1994) How to Use Financial Statements: A Guide to Understanding the Numbers. McGraw-Hill Professional. Pp. 26-67
  6. Bernstein, L. A. & Wild, J. J. (1999) 5th Ed. Analysis of Financial Statements, McGraw-Hill Professional. Pg. 124
  7. Clearly, S., (1999) The Relationship between Firm Investment and Financial Status, Journal of Finance 54, 673-692
  8. Diamond, D., (1991) Monitoring and Reputation: The Choice between Bank Loans and Directly Placed Debt, in ”Journal of Political Economy”, n. 4, pp. 89-112
  9. Dyck, A. & Zingales, L. (2004) ‘Private Benefits of Control: An International Comparison, Journal of Finance 59
  10. FASB Discussion Memorandum, (1980) Reporting Funds Flow: Liquidity and Financial Flexibility, FASB, Stanford.
  11. Gill, J. O. & Chatton, M (1999) 3rd Edn. Understanding Financial Statements: A Primer of Useful Information. Cengage Learning
  12. Graham, B. & Meredith, S. B. (1998) The Interpretation of Financial Statements: The Classic 1937 Edition. HarperBusiness
  13. Hey, C. D. (2007) 4th Edn. Financial Statements Demystified. Allen & Unwin
  14. Kaplan, S. and Zingales, L. (1997) Do Investment-Cash Flow Sensitivities Provide Useful Measures of Financing Constraints. Quarterly Journal of Economics 107
  15. Myers S., & Majluf, W. (1984) Corporate Financing and Investment Decision When Firms Have Information that Investors do not Have, Journal Of Financial Economics. Vol. 13, n 2, pp. 145-156

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