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The Daily Technical #66: When do you capitalize vs. expense items under accrual accounting?

How to answer "If you had to pick between either the income statement or cash flow statement to analyze a company, which would you pick (and why)?"

December 11, 2024

Good morning. Welcome to the 66th edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
If you had to pick between either the income statement or cash flow statement to analyze a company, which would you pick (and why)?

When choosing between analyzing the income statement or cash flow statement, select the cash flow statement.

It reveals true liquidity and avoids discretionary accounting practices found in accrual accounting.

Both equity investors and lenders need to prioritize a company's capacity to generate free cash flow for reinvestment and debt repayment.

However, if evaluating an unprofitable company with negative net income and cash flows, consider the income statement. It can help assess value using revenue multiples. Ultimately, "cash is king," but profitability can shift focus to the income statement.

Common Mistakes

  1. Mistakenly prioritizing the income statement, forgetting that the cash flow statement reveals liquidity and real cash on hand. Always remember that "cash is king," and analyzing liquidity offers insight into a company’s solvency and operational health.

  2. Not considering how accrual accounting can distort the income statement. Focus on cash flow for a clearer picture, sidestepping potential accounting manipulations that mask financial realities.

  3. Focusing solely on cash flow and overlooking situations where profitability details are crucial. For unprofitable companies, incorporate income statement insights using revenue multiples to gauge future potential.

TL;DR

  • Choose the cash flow statement for direct insights into liquidity and true cash position, bypassing accrual accounting's subjectivity.

  • In unprofitable scenarios, the income statement becomes more relevant for assessing growth potential through revenue multiples.

TODAY’S QUESTION
When do you capitalize vs. expense items under accrual accounting?

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THAT’S A WRAP
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