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Accounting Questions

1. How could a firm that is very profitable on its income statement find it difficult to pay its expenses (commitments) as they come due?

2. Explain how depreciation relates to income and cash flow.

3. Consider gains or losses on non-recurring asset sales. How could they mislead management and potential investors on a cash flow basis?

4. As the time period under consideration increases, how would the relationship between income and cash flow change? Compare and contrast.

5. Contrast the indirect and direct methods of cash flows. What is the particular value of each?

6. What benefit does a firm receive from securitization of assets such as accounts receivables? How does that impact the cash flow of a firm?

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1. How could a firm that is very profitable on its income statement find it difficult to pay its expenses (commitments) as they come due?

An income statement measures the profitability of a company over a specific period of time. The income statement does not measure the ability of a company to pay its commitments as they come due. Liquidity can become a problem for an otherwise profitable entity if there is not a sufficient cash reserve to cover expenses. This situation can happen in a number of ways. A liquidity problem in a profitable company whose customers purchase primarily through A/R that comes due over a period of time that extends past the date the expense for the product purchased comes due. A self-financing car company is a good example. If a company sells cars and finances the sales in house then the car company will be receiving payments on a can sold in year 0 over 5 years. Nevertheless, the car company will owe the cost of the good sold (the car) in year 0. The income statement will recognize the sale and expense in the current period and the car dealer will appear profitable. Indeed, as long as the car dealer has enough cash reserve to cover the expense the car dealer will not have a going concern issue. However, if the cash reserves are depleted or sales suddenly fall to a point that the dealer does not have the continued revenue stream to support the financing process, the dealer might find it difficult to pay its expenses.

2. Explain how depreciation relates to income and cash flow.

Depreciation relates to income by allowing an asset that is used over time to be recognized as an expense in the ...

Solution Summary

Answers the following questions:
1. How could a firm that is very profitable on its income statement find it difficult to pay its expenses (commitments) as they come due?

2. Explain how depreciation relates to income and cash flow.

3. Consider gains or losses on non-recurring asset sales. How could they mislead management and potential investors on a cash flow basis?

4. As the time period under consideration increases, how would the relationship between income and cash flow change? Compare and contrast.

5. Contrast the indirect and direct methods of cash flows. What is the particular value of each?

6. What benefit does a firm receive from securitization of assets such as accounts receivables? How does that impact the cash flow of a firm?

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