Income Statement Cash Flow
By comparing income statements with the relevant cash flow statement, you can see how much of the profit being shown is supported by cash actually coming into the company.
A cash flow statement shows the amount of cash an organization has coming in and going out over a certain period. If you need further details and explanation of a cash flow statement then you can download for free our eBook 'Understanding Cash Flow,' which describes this statement in detail.
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Booming profits on the income statement and weak, or even negative, cash flow means that the quality of the earnings being shown is poor.
There are certain circumstances, for example a start-up, where it may be acceptable to have positive, growing net income and negative cash flow. This is because the new organization has to make substantial investments and may not be collecting from its customers yet.
In the case of a more established company, cash flow and net income should be highly correlated. Once an organization has matured, it should be receiving cash from existing customers as well as selling to new customers, so the cash flow should have caught up.
As previously described, the revenue on the income statement does not necessarily represent the cash that is actually coming into the organization. So it is important that you know how that revenue is being determined because accounting rules allow for some discretion under the accrual method.
What this means in terms of your analysis is that you have to watch out for instances where an organization is trying too hard to make the numbers look better by recognizing sales too early. At what point during the sales process does it reflect revenue on its income statement?
• Is it when they take an order or when they deliver the goods or services?
• How do they record revenue for sales completed over a long period of time?
• Do they have problems with revenue collection or bad debt?
Understanding how aggressive an organization is in their revenue recognition helps you determine the quality of the data that is shown on the income statement.
This also applies to expenses such as depreciation and amortization. For example:
An industry standard for depreciating an asset is 10 years, but the organization spreads it out over 20.
By altering the way it allocates its depreciation in this way the organization will appear more profitable than their competitors who are using the industry standard, which is a less aggressive accounting practice.
In short, you need to identify the areas where an organization has a lot of accounting discretion and figure out how aggressively or conservatively it's being done. If you want to refresh or clarify your understanding accounting practices then download our eBook 'Accounting Principles' available from this website.
You may also be interested in:
Income Statement Definition | Income Statement Format | Multiple-Step Income Statement | Income Statement Explained | Operating Expenses Definition | Income Statement Ratios | Common-Size Income Statements | Common-Size Analysis.
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