Question

Financial statements all have a goal. The statement of cash flows does as well. Describe how the statement of cash flows helps investors and creditors perform each of the following functions a Predict future cash flows. b. Evaluate management decisions c. Predict the ablity to make debt payments to lenders and pay dividends to stockholders. a. The statement of cash flows helps predict future cash flows by reporting cash which are good predictors of future cash flows.

Answer 1

(A) Predict future cash flows

A positive net cash inflow doesn't always mean that the business is sustainable. The ability of a company to generate future cash flows depends on it's Quality of Earnings. A company's real quality of earnings can only be revealed by spotting and removing any abnormal events, accounting tricks, or one-time events that skew the numbers. For example, Issue of shares or Sale of assets might provide a high net cash inflow during the year, but the same is not expected to recur in the coming years. Hence, the sustainability of the business is majorly determined by the Operating cash flows i.e. the day-to-day routine activities.

(B) Evaluate Management Decisions

The cash-flow statement is one of the most important documents for evaluating management decisions. While the company can look profitable based on standard accounting methods, the cash-flow statement would give a clear image of whether the company has the cash to pay its bills over the short-term.

Net income and earnings can be manipulated to paint a healthy financial picture, but the cash-flow statement presents the reality of the company’s ability to maintain operations. A drop in the company’s operating cash-flow ratio should trigger a red flag, indicating that there is a need to reassess pricing, inventory, overhead, debt, and other short-term decisions to improve the company’s cash position.

(c) Predict the ability to make debt payments to lenders and pay dividend to stockholders

As mentioned in part (a), the sustainability of a business can be measured through it's Quality of Earnings. Let's say, a company has low accounting profits or has incurred losses during the year. However, if we analyze the cash flow statement, there is a possibility that the company has recently invested in purchasing new assets for the expansion of the business, which has led to high depreciation claims and thus low accounting profit. Thus,even though the company might have low accounting profits or has been incurring losses over the years, the same is because of expansion pursued by the management, and the cost incurred would be recovered in the coming years, in order to repay the debt holders and shareholders.