According to Rob Olsen in his book: "Credit Professional's Handbook," the Balance Sheet and Income Statement are readily understood and intuitive, but the Statement of Cash Flows is not. Olsen suggests that if analysts understood the interrelationship between the Statement of Cash Flows and the Balance Sheet and Income Statement they would find the Statement of Cash Flows to be easier to use and more meaningful in their financial analysis. According to Olsen, the Statement of Cash Flows primary purpose is to provide information regarding a company's cash receipt and cash payments. The statement complements the Income Statement and Balance Sheet. He explains that over the life of a company, total net income and net cash inflow will equal. However, since income determination is based on accrual accounting, income and cash flow rarely equal even over the small of an annual accounting period. Thus, the Statements of Cash Flows becomes and important tool for analyst to determine if a company is generating sufficient cash flow to meet its current needs and current financial obligations. Also, the higher the correlation between net income and cash flow, the higher the quality of earnings.
The Income Statement and Balance Sheet are compiled based on accrual accounting method that was developed based on the concept of matching. The matching principle states that revenues generated and expenses incurred to generate those revenues should be reported in the same Income Statement. However, it is often the case that expenses result from accruals and allocations that do not affect cash. Thus, the Statement of Cash Flows reports changes in the cash position of a company while the Income Statement reports profits and losses.
There is also an interrelationship between the Income Statement and the Balance Sheet. Specifically, net income after tax minus dividends paid, as reported on the Income Statement, is added to the retained earn...