Importance of cash flows

Essay by rishi30University, Master'sA, October 2006

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The statement of cash flows is important because cash is what allows a

business to function. A firm can have plenty of income on its income

statement but still wind up in financial difficulty if it lacks

appropriate amounts of cash at the right times. Revenues and expenses

on the income statement can differ from that period's cash receipts

and disbursements because of two factors: accrual accounting and

nonoperational sources of cash. Accrual accounting typically results

in revenue recognition being separated from the actual receipt of

cash, and expenses are treated likewise. Nonoperational sources and

uses of cash do not contribute to the firm's income and expenses, but

they can play a critical role if insufficient cash is available to

meet obligations resulting from financing, such as debt repayment or

an expected dividend.

The operations section is important because successful companies are

able to generate cash through their ongoing operations.


generation of additional cash beyond the expenses required to generate

it is what allows the firm to pay dividends, invest in its business,

and manage its indebtedness. Companies that fail to generate cash

from operations over a significant period of time tend to wind up in

financial distress and bankruptcy. This measure is particularly

important, therefore, to both a firm's managers and its investors.

The investing section shows whether or not a firm is growing and

replacing equipment as it wears out. Investors are particularly

interested in this to see if the company is investing in its business

for growth or underinvesting, which will typically signal that growth

opportunities are lacking and that the firm's ability to produce will

eventually decline.

The financing section is important because it tells investors whether

or not the firm is diluting the value of their investment through the

issuance of more stock or...