Businessman Investor

Touching base with the rational business psyche of stock market investors

Tuesday, August 16, 2011

Cash Qualifying the Income Statement

This is Part 2 of a Series. Go to Part 1: By Sheer Business Instinct, We Know that Cash is King

The Income Statement is a handy-dandy financial statement readily available and can be used easily to evaluate a firm's profitability. It cleanly breaks down the revenues, direct expenses, gross profit, operating expenses, and net income. However, it falls short of presenting the whole picture in terms of a firm's liquidity. Liquidity is a financial concept that measures and captures a company’s ability to collect cash revenues and pay off cash expenses.

Not just profitable, but liquid. Quality businesses demonstrate their superior economics if they are able to maintain a healthy flow of internally-generated cash. The Income Statement can't show that, so you need to cash qualify it with the Cash Flow Statement.
The Income Statement doesn't tell you what portion of the revenue is actually received in cash or how much cash was paid for purchases of inventory and for operating expenses. Let's admit it, although accrual accounting (which is the basis of the Income Statement) is very useful and clever—and may I note, probably one of the best inventions of mankind—it can be, sad to say, misleading or deceiving. I say this because a company may indeed be profitable, but is not realizing those profits in cash. That’s the role of the Cash Flow Statement; it can be used in conjunction with the Income Statement to qualify cash transactions, and ultimately, cash profits.

Take note that as I carry along, I’d be assuming a manufacturing or a retailing business (these are simpler and more familiar to many of us). This is critical to note because the nature of cash flow can greatly vary from industry to industry (banks and finance-related businesses, for example, are rather more complex, and not as straight-forward). Further, while we shall discuss its different features, keep in mind that you want to be centrally focused on internally-generated cash. Cash flow can be confusing because of its diverse nature (e.g. there may be cash coming in but not by virtue of business operations such as externally sourced capital). Again, as a businessman investor, what you seek and mindful of are cash generated internally by the business. Continue to Part 3: Showing You the Money and Natures of Cash Flow

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