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Importance Of Cash Flows Essay

586 words - 3 pages

The statement of cash flows is important because cash is what allows abusiness to function. A firm can have plenty of income on its incomestatement but still wind up in financial difficulty if it lacksappropriate amounts of cash at the right times. Revenues and expenseson the income statement can differ from that period's cash receiptsand disbursements because of two factors: accrual accounting andnonoperational sources of cash. Accrual accounting typically resultsin revenue recognition being separated from the actual receipt ofcash, and expenses are treated likewise. Nonoperational sources anduses of cash do not contribute to the firm's income and expenses, butthey can play a ...view middle of the document...

Companies that fail to generate cashfrom operations over a significant period of time tend to wind up infinancial distress and bankruptcy. This measure is particularlyimportant, therefore, to both a firm's managers and its investors.The investing section shows whether or not a firm is growing andreplacing equipment as it wears out. Investors are particularlyinterested in this to see if the company is investing in its businessfor growth or underinvesting, which will typically signal that growthopportunities are lacking and that the firm's ability to produce willeventually decline.The financing section is important because it tells investors whetheror not the firm is diluting the value of their investment through theissuance of more stock or is increasing the firm's risk through theissuance of more debt. Conversely, share buybacks and the retirementof debt can serve to increase investors' confidence in the company. Afirm that is generating most of its cash through financing activitiesis either likely to be in a high-growth stage or is likely to be indecline shortly. Whether the funds are being invested in plant andequipment, are being used for share buybacks and/or dividends, or arelanguishing as cash gives investors an idea of which scenario is mostlikely.By preparing the statement of cash flows using the indirect method, welose information contained within the detailed transactions. We onlyknow the net effect. For example, production equipment and/ormerchandise inventory could have been both purchased/manufactured andsold during the month, but we can only see the net effect of whatcould be multiple transactions

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