Financial statements -- the income statement and statement of cash flows -- report accounting profit and cash flow, respectively. Both figures are important to a business. The information gleaned from these reports, however, is vastly different. Understanding the differences between the two is necessary to properly ascertain a company's financial health.
Financial statements -- the income statement and statement of cash flows -- report accounting profit and cash flow, respectively. Both figures are important to a business. The information gleaned from these reports, however, is vastly different. Understanding the differences between the two is necessary to properly ascertain a company’s financial health.
Accounting profit is the difference between a company’s revenues, cost of goods sold and expenses. The first item represents money coming in, while the latter two items represent money going out of the business. This figure, called "operating profit," is fictitious number since it has no physical representation in the company’s business operations. Non-operating items can increase or decrease accounting profit. These include the sale or disposal of assets and other one-time items.
Cash flows represent the different sources and uses of cash in a business. Cash is a physical asset companies track through bank accounts, statements and reconciliations. Companies use the income statement and balance sheet to prepare the statement of cash flows. Three main activities -- operating, investing and financing -- represent the sources or uses of cash. Revenues and operating expenses are part of the first section, derived from the company’s current income statement.
Companies can have high sales revenue but little cash on hand to run operations. In business, companies in this situation are cash poor. The most common way for this to occur is when a company has copious credit sales that boost revenues while creating a drain on cash. Credit sales typically allow customers 30 days or more to pay for goods or services purchased. Though a boost to accounting profit, cash flows decrease as operating expenses increase with no offsetting cash inflows from current sales.
Accrual accounting is notorious for its inability to accurately track cash flows. The reason for this comes from non-cash items included on the income statement. Depreciation and amortization, for example, are valid income statement expenses that have no place on the statement of cash flows. In order to correct this difference, accountants may need to add a section or disclosure on the statement of cash flows identifying all non-cash items, informing financial statement users about the presence of these items.
- "Fundamental Financial Accounting Concepts"; Thomas P. Edmonds, et al.; 2011