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
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...