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Income Statement Versus Cash Flow Statement in Company Financial Analysis

Both the income statement and the cash flow statement are important in company financial analysis.
Discuss the usefulness of earnings (and the income statement) and cash flows (and the cash flow
statement) in predicting future cash flows and stock returns.
The articles listed below are only a starting point:
(a) Barth, M.E., P.C. Donald and K.K. Nelson (2001), Accruals and the Prediction of Future Cash
Flows, The Accounting Review, Vol. 76, No. 1, January, pp. 27–58
(b) Finger, C.A. (1994), The Ability of Earnings to Predict Future Earnings and Cash Flows, Journal of
Accounting Research, Vol.32, No.2, Autumn, pp.210-223.

Sample Paper

Income statements and cash flow statements are considered vital documents in the prediction of the company’s financial performance. The statement can be adopted in the prediction of the future cash flows, earnings, or stock returns that can be reported by an organization. Different studies have been done to investigate the predictive role of cash flows drawn from the cash flow statement, and earnings obtained from the income statement. A number of studies have reported the significant role of cash flows in predicting future cash flows and stock values. In fact, the studies show that cash flows are more superior in the prediction of cash flows and stock value in relation to the current earnings of the organization. On the contrary, some studies have reported the significance of earnings in predicting stock value, though they are considered less effective in predicting the company’s cash flow. Despite the mixed findings on the predictive role of cash flows and earnings, it is deduced that profits can be misleading and are thus not better predictors of future cash flows of a company’s stock return.  This paper presents a comparative analysis of the cash flow statements and income statements in their prediction of the future cash flows or stock return of a company

Shareholders depend on economic information and facts, like income and funds-linked activities, to calculate a firm’s intrinsic worth importance and anticipate the go across-region of recurrent income. Fama and French (2006) find that more lucrative companies have better-anticipated earnings. Novy-Marx (2013) demonstrates that profits, calculated by gross earnings-to-assets, forecasts the go across a portion of common results equally well as book-to-industry ratios do. Fama and French (2015) add a profitability measure being a new element, stretching their popular three-component model. Hou, Xue, and Zhang (2015a and 2015b) create a q-component model that contains an earnings element, which does nicely in outlining anomalies. Soccer ball et al. (2015a) demonstrate that running profitability determines that far better suits recent expenses and revenues is an even better forecaster of earnings and also show that results rely on if the denominator is over all belongings or the market value of home equity. Hence, the look for proceeds for economic information and facts that far better forecasts stock profits. Even though the cash flow declaration is definitely at the core of financial statement evaluation, properly-reported shortcomings1 get in touch with into query the efficiency of relying on its parts to

1 See Sloan (1996) and Markham (2006). See also more generally, American Institute of Certified Public Accountants (1973). The committee, chaired by Robert Trueblood, urged the accounting profession to be more 2 value stocks and predict stock returns. Notorious bankruptcies including Enron and WorldCom, graphically illustrate that profitable GAAP income statements can simultaneously co-exist with negative operating or free cash flows for the same company for long periods of time (see Appendix A for a typical representation). More specifically, we believe existing GAAP requirements permit too many alternative types of financial statement presentations, such information is too aggregated, and can be inconsistently presented making it difficult for users to understand the relationship between how accounting information is presented and the underlying economic results of the firm. Novy-Marx’s (2013) intuition that the farther down the income statement one goes, the more “polluted” profitability measures become and less related to “true” or economic profitability certainly rings true. Yet it is not obvious that any accrual accounting profit measure, regardless of where on the income statement it appears, should be superior to cash-based measures of performance and value. In theory, if financial information is sourced from the same underlying economic data there should be no difference between using information derived from either the income or cash flow statement when making investment decisions. If, however, this assumption does not hold (as was the case with Enron and Worldcom) then it is possible the income statement may depict one state of affairs while the cash flow statement another. It is our belief that the lack of uniformity amongst the reported statements and their disjointed presentation makes it extremely difficult for investors to test the quality of a corporation’s historical earnings and compare the results within or across industries. Our work reveals that by introducing a standardized ‘direct cash flow’ template investors can better understand the historical, contemporaneous and forecasted return potential of a firm. Both International Financial Reporting Standards (IFRS) and U.S. GAAP encourage firms to present operating cash receipts and payments using the direct method of financial statement presentation. The vast majority of firms, however, elect to present operating cash flows using the indirect method. Unfortunately, when the indirect method is used, it presents no operating cash receipts or payments in the statement of cash flows.2 Instead, it merely reconciles net income to

reactive to purchasers and bank loan suppliers in offering info about the organizations they audited and existing significantly less deference to corporate management. 2 The data processing common for presenting the document of cash flows is documented from the Economic Data processing Specifications Table (FASB) (1987), identified simply as FASB 95 or FAS 95. Particularly, see site 6 that suggests “The 3 ‘operating income flow’ by adjusting for bookkeeping items that do not make or use money which includes: depreciation, alterations in credit accounts receivables, payables or taxation and stopped functions, restructuring or particular costs. As a result, the important points provided in the indirect income statement include noncash running things included in internet revenue (or reduction) instead of operating cash statements and repayments. In addition, it can be extremely hard to version the degree, consistency, timing, and volatility of prospective cash flows because inflows and outflows are not collected based to typical monetary characteristics.3 Consider the simple instance of a transaction manufactured fully on credit score. A rise in accounts receivable caused by a customer’s delayed obligations foliage both revenues and world wide web income are unaffected just as if the complete transaction was received. It can be only by looking at a separate operating income document that consumers discover that cash inflows were actually lowered and accruals have been increased by the identical quantity. Moreover, changes in balances receivables usually are not assembled with its easy-to-use financial associate ‘revenues’ but rather with ‘working funds changes.’ The shortcoming is obvious: the indirect cash flow document hard disks net cashflow from operating actions without separately presenting the functioning funds’ invoices and obligations. Although the FASB sees accruals as improving the potential of income to evaluate business efficiency by smoothing out “temporary” variances in money runs, we perceive the absence of money inflows in the tardy buyer and the resulting irregular presentation across many economic claims as rich soil for safety mispricing.