Question

The cash flow statement was not required by GAAP until 1988. Why do you think the SEC added the cash flow statement to the required annual reports? What is its importance for managers and external investors? What is the importance of Ratio Analysis for both management and external investors? (Answer in one or two brief, but well-developed, paragraphs.)

Answer 1

Income statement is prepared on accrual basis concept hence it would have income and expenses which do not have actual cash inflow or outflow for example: goods sold on credit basis, depreciation and amortization expenses, gain or loss on sale of fixed assets and investments, etc. Hence Income statement does not give an idea of cash flows generated by business during the year. To overcome this drawback cash flow statement is prepared since it helps users in understating how cash flow movements take place during the year.

The importance of cash flow statement in recent years has increased due to many firms becoming bankrupt due to non availability of cash in their operations. Cash flow is important to investors and managers due to following reasons:

· Helps in understanding working capital movement due to operating activities.

· It helps in understanding solvency of the firm through cash availability from operating activities.

· Helps in raising capital and investment decisions like purchase of fixed assets for future growth of business.

· Helps in arranging long term finance based on the forecast of cash flow through bonds , debts, bank borrowings, etc

· Helps in taking short term decisions regarding financial requirements like short term notes or bank borrowing

· Helps in managing cash which is pivotal to any business. A business which is well managed with cash will rarely find solvency related issues

· Helps in understanding free cash flows available to shareholders. Free cash flows are cash flow from operating activities minus the capital expenditure.

Ratio analysis is a method of understanding and analysing financial statements. They help in interpreting the numbers in a meaningful way which can be used for improving performance of the firm. They also indicate the healthiness and worth of the business. Ratio analysis would indicate a firm’s performance in area of profitablity, liquidity, solvency and operating efficiency.

· They help in understanding profitablity margin of the business. For example : Gross margin , Operating margin, net margin ,etc

· They help in understanding how efficiently assets are deployed in the business. for example: Return on assets, Assets turnover ratio,

· It helps in measuring liquidity of business. for example: Current ratio indicates the ratio of current assets available for payment of current obligations

· It helps in understanding relationship between variables of financial statement. For example Inventory days on hand, Sales days outstanding, days payable outstanding, etc

· They help in identifying inefficiencies in business due to operating assets. For example : non moving inventories, bad collection policies, etc

· It helps in working capital management through monitoring current assets and current liabilities

· It helps in understanding and managing solvency of the business. For example interest coverage ratio, debt service ratio, Debt equity ratio and Debt to total assets ratio

· The help in understanding cash flows of the business. For example: Cash flow to current liabilities ratio. Cash burn rate, Cash flow to debt service etc