Summary
While the Income Statement measures accrual-based profitability over a period, it can be insufficient or even misleading when assessing a company’s actual Liquidity or cash position.
Key Reasons
- Timing Mismatch (Accrual vs. Cash): Revenue is recognized when earned, not necessarily when cash is received. A company can show high Net Income but struggle if customers don’t pay (high Accounts Receivable).
- Non-Cash Items: The IS includes significant non-cash expenses like Depreciation & Amortization (D&A) that impact Net Income but don’t represent actual cash outflows during the period.
- Management Discretion: Accrual accounting allows for management judgment (e.g., useful life assumptions, allowance for doubtful accounts), which can be used to manage earnings and may not perfectly reflect the underlying cash reality.
Complementary Statement
The Cash Flow Statement is essential as it reconciles Net Income to the actual change in cash by adjusting for non-cash items and changes in working capital, providing a clearer view of liquidity.
See also: Income Statement, Cash Flow Statement, Liquidity, Accrual Accounting