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Discussion Question 1
Why does the income statement not present the cash inflows and outflows? Why is the income statement a very important statement?
The income statement is normally drafted on an accrual basis. Accrual accounting recognizes income when earned and expenses when incurred. This means that income recognized on the income statement will not always indicate actual money into an organization. Likewise, expenses on an income statement prepared on the accrual basis will not have been necessarily paid out, only recognized. The income statement is important, however, because it helps an organization properly match its revenues to the expenses incurred to obtain those revenues. This helps an organization understand its costs of business and control this so it can improve its profitability.
Does net income mean we have cash in the bank? Why? Or, why not?
Net income is not the same things as cash in the bank. When net income is calculated on an accrual basis it only represents a calculation of the excess of revenues over expenses. Because accrual accounting recognizes revenues when earned but revenues are not always collected when earned, revenues themselves are not actual cash income. Likewise, accrual accounting recognizes expenses when incurred, but expenses are not always incurred and paid at the same time. Therefore, expenses do not mean any cash payments were necessarily made. Only the movement of actual cash into and out of a building can alter the amount of money a business has in the bank. As a result, when net income is an accrual amount, it is not the same as cash in the bank.
If the accounts in the income statement are in dollars, are those accounts cash inflows or cash outflows?
Simply because the amounts on the income statement are in dollars does not mean those accounts represent cash inflows or cash outflows. All the dollar amounts indicate are that the currency used to indicate the amounts on the income statement are in dollars. Any income statement prepared on the accrual basis will not reflect cash inflows and outflows. The accrual basis represents only that revenues were earned (not collected, which is when the cash amount is taken into the business) and that expenses were incurred (which is not the same as payment being made, and only when payment is made does cash flow out of the business).
Discussion Question 5
What are the perspectives of using ratio analysis? Why do you think companies and investors use ratios?
Ratio analysis allows people to evaluate the performance of an organization from year to year as well as against other firms in its industry. These comparisons can be used to evaluate whether the organization’s financial performance is showing a positive trend, such as decreasing debt ratios or improving current ratios, or whether the organization is showing a negative trend. Further, by comparing the ratios of one organization to its competitors in the same industry one can determine how well managed and financially stable an organization is in comparison to those in the same industry. This allows a comparison of “apples to apples,” as it were, rather than simply comparing dollar amounts, which provide little ability to evaluate financial strength through such a comparison. These are the reasons companies and investors use ratios rather than simple comparisons of dollar amounts over time.
If you have to use only five ratios (not categories) to make your decision, what would those five ratios be? Why?
The five ratios I would focus on would be: (1) the debt to equity ratio, (2) the current ratio, (3) the debt ratio, (4) the return on assets, and (5) the return on equity. The debt to equity ratio indicates the level of leverage, or debt, an organization has. The lower the number the more debt an organization relies on to remain in business and this factor can indicate that an organization can easily suffer damaging debt costs if its sales decrease, the economy worsens, or its lenders raise interest costs. The current ratio helps determine how well an organization can meet its current liabilities using nothing more than its current assets. This ratio provides an indication of how effectively an organization can meet the debts that it must pay in the short term and its liquidity. The debt ratio (total debt over total assets) indicates how much of an organization’s assets can cover the organization’s total debt, a measure of the firm’s solvency. Both return on assets and return on equity indicate how effectively the organization uses its assets and how well shareholders can expect their investments to increase in value.
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