How to answer this question
To successfully answer this question, you need to make sure that you clearly illustrate your understanding of cash vs. accrual accounting. You need to recognize that both statements are important yet each has its own purpose (a related question revolves around the difference between EBITDA and free cash flows).
Poor answers to this question include ones that don’t discuss the purpose of each statement and specifically the differences (cash vs. accrual accounting).
Sample great answer
The income statement shows a company’s accounting-based profitability. It illustrates a company’s revenues, expenses, and net income. Income statement accounting uses what is called accrual accounting. Accrual accounting requires that businesses record revenue when earned and expenses when incurred.
Under accrual method, revenues are recognized when earned – not necessarily when cash is received – while expenses are matched to associated revenue – again not necessarily when cash goes out the door. The benefit of the accrual method is that it strives to show a more accurate picture of the companies profitability. However, focusing on accrual based profitability without looking at cash inflows and outflows is very dangerous, not only because companies can more easily manipulate accounting profits than they can cash profits, but also because not having a handle on cash can potentially make even a healthy company go bankrupt.
Those shortcomings are addressed by focusing on the cash flow statement. The cash flow statement identifies all of the cash inflows and outflows of a business over a certain period of time. The statement utilizes cash accounting. Cash accounting is the system used to keep track of actual cash inflows and outflows. What this really means is that since not all transactions are made with cash (i.e., accounts receivable), such transactions would be backed out of the cash flow statement.
Cash accounting literally tracks the cash coming into and out of the business. One final point on cash vs. accrual accounting is that the differences between the two accounting systems are temporary timing differences that will eventually converge.
The key to financial analysis is to use both statements together. In other words, if you have incredibly high net income, such net income should be supported by strong cash flow from operations and vice versa. If this is not the case then you need to investigate why such a discrepancy exists.