How to Read a Financial Report: Wringing Vital Signs Out of the Numbers, 8th Edition

CHAPTER 3

PROFIT ACCOUNTING

An Important Question

In Chapter 2 we introduce the three primary financial statements for a representative business example. See Exhibits 2.1 (balance sheet), 2.2 (income statement), and 2.3 (statement of cash flows). These three financial statements provide a comprehensive financial summary of the business. In reading these three financial statements did anything pique your curiosity? Did something in the financial statements stop you in your tracks and raise a question in your mind?

Well, one thing might have caught your attention. In its income statement for the year (Exhibit 2.2), the company reports that it earned $2,642,000 net income, or bottom-line profit. On the other hand, in its statement of cash flows for the year (Exhibit 2.3) the company reports that it generated $3,105,000 cash flow from operating activities, that is, from profit-making activities. In short, profit is $2,642,00 and cash flow from profit is $3,105,000 for the year.

Wait a minute: How can cash flow from profit be higher than profit? Where did the “extra” cash come from? In other situations could cash flow be less than profit? A simple answer is that profit, or more accurately the revenue and expenses that determine profit consist of more than just cash flows. Actual cash inflow from revenue is typically higher or lower that the amount of revenue recorded for the period. And, actual cash outflows for expenses are typically higher or lower than the amounts of expenses recorded ...