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Statement of Cash Flows, Financial ratios

1. Why is depreciation included in the statement of cash flows?
2. What are the shortcomings of analyzing a company using only one financial ratio?
3. Why has the statement of cash flows become a more popular tool for financial analysis over the past few years?
4. Why is it important to use both horizontal and vertical analysis in analyzing financial statements?
5. What ratios do mortgage companies use in determining the qualifications of home buyers?

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Use has been made of material at the following sites*:

http://www.iabusnet.org

www.nva-mortgage.com

1. Why is depreciation included in the statement of cash flows?

Depreciation is a non cash expense. It has been subtracted from revenue to arrive at the net income. However depreciation does not involve any outflow of cash. Therefore it is added back to net income in the statement of cash flows to arrive at the cash flow from operations.

2. What are the shortcomings of analyzing a company using only one financial ratio?

If we analyze a company using only one ratio we do not get the complete picture. Thus if we measure only the profitability ratio we may find the company to be making profits and we may decide to invest in it. However if the liquidity of the company is poor (but this fact is not revealed as we have not used the liquidity ratio) it may be heading for trouble and liquidation.

3. Why has the statement of cash flows become a more popular tool for financial analysis over the past few years?

Over the life of a company, total net income and net cash inflow will be equal. However, since income determination is based on accrual accounting, income and cash flow will rarely be equal in an annual accounting period. A company may operate for several years because its cash inflows exceed its required cash payments, even though the company may not be profitable in the long run.
The income statement and balance sheet are based on accrual accounting which was developed based on the concept of matching. The matching principle states that revenues ...

Solution Summary

The solution discusses some aspects of Statement of Cash Flows Financial ratios.

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