Sunday, March 7, 2010

Know Your Financial Statements: The Income Statement and the Statement of Cash Flows


In the last post, we learned how the balance sheet presents important information about the firm’s investing and financing activities. The next major financial statement, the income statement, presents the status of the firm’s operations for a specified period of time. Below we see Narra’s latest income statement:

The firm’s net income shows how much money the firm makes in the specified period, net of all expenses; if the firm spends more than the sales it generates, then it incurs a net loss. Looking at Narra’s latest income statement, the 721,000 pesos net income it earned is a sign that it has done well in 2009. Revenues (or sales) measure inflows of assets like cash or accounts receivable (unpaid purchases of customers), while expenses (or costs) measure outflows of such assets. The basic income statement formula is shown here:


Intuitively, the goal of any business should be to maximize net income, either by maximizing revenues or minimizing expenses, or by doing both. We have to be careful, though, and remember that net income includes noncash items like accounts receivable and depreciation (used to account for the periodic usage of fixed assets), and therefore is often an unreliable measure of how much cash the firm is able to generate (and spend!).

The statement of cash flows reports the cash inflows and outflows from the firm’s various business activities for a period of time. In Narra’s latest statement of cash flows below, we see that cash flows (cash outflows are in parentheses) are grouped into the firm’s three main business activities: operating, investing, and financing activities.

From Narra’s latest statement of cash flows above, we see that we have to make some adjustments to net income before we can derive how much cash the business was able to generate. Depreciation, a noncash expense deducted from revenues in the income statement, needs to be added back. Also, noncash inflows like accounts receivable and inventories need to be removed. The resulting figure is the cash generated by the company’s operations, often called cash from operations or CFO.

Investing cash flows include purchases (or sales) of noncurrent assets like machinery, vehicles, land, factories, or office buildings.

Financing cash flows include debt repayments and availments, and cash dividend issues.

The cash flows from the three activities are added to determine the net cash inflow or outflow for the period. From Narra’s statement of cash flows, we see that in 2009 the firm generated a net cash increase of 451,000 pesos.

To summarize, let’s take a look at how the three financial statements are related to each other: the balance sheet shows the results of the firm’s investing and financing activities and the income statement details its operating performance; the statement of cash flows ties everything together by presenting the cash generated or used by these three activities. Therefore in making important financial decisions, the statement of cash flows provides the most important, relevant, and complete information; successful investors and entrepreneurs know that a firm’s value is derived not from the worth of the company’s assets in the balance sheet, or from sales or accounting profit, but from how much cash the firm can generate in the future. Nevertheless, all three financial statements are very important in understanding how promising (or unattractive) a company’s prospects are. So if you want to know how well your business is doing, or if a stock you’re pining for is a good buy, or if a potential supplier is as reliable as it purports to be, spend a few moments reading the firm’s financial statements; just like googling a girl’s name before going out on a date with her, you’ll see that the extra trouble will be well worth it.
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