What it means
The income statement shows profit and the balance sheet shows what the company owns and owes. The cash flow statement fills the gap by showing where cash actually came from and where it went.
It links the other two statements and reconciles opening cash to closing cash. Operating activities cover the cash from the core business: customer receipts, supplier payments, wages and taxes.
Investing activities cover the purchase and sale of long-term assets, such as equipment, property and investments in other companies. Financing activities cover loans, share issues, dividends and buybacks.
The three sections add up to the net change in cash for the period. Adding that change to the opening balance gives the closing cash on the balance sheet.
If the numbers do not tie, there is an error somewhere in the accounts. Reading the statement tells you a great deal quickly.
A company that funds its investments from operating cash flow is in a different position from one that relies on borrowing. Profitable companies can still fail if they run out of cash, which is why lenders and investors read this statement closely.
There are two methods of presenting the operating section. The indirect method starts with net income and adjusts it, and the direct method lists actual cash receipts and payments.
Both give the same total, and most companies use the indirect method. For managers, the statement is a tool for judging whether growth is affordable.
Rapid expansion often absorbs cash through stock, receivables and equipment, even when profit is rising. Seeing it laid out helps in planning funding before the cash runs out.
In practice
Real-world examples
Example 1
A software company shows strong operating cash flow of $2,000,000 and small investing outflows of $300,000. It has no debt to repay. Its cash balance grows steadily, giving it room to acquire smaller rivals. Management uses the surplus to repay no debt at all and focuses on growth instead, with an eye on the cash balance each quarter.
Example 2
A fast-growing retailer reports profit but negative operating cash flow because it is building stock for new shops. The financing section shows a new bank loan of $5,000,000. The statement reveals that growth is being funded by borrowing.
Example 3
A mature manufacturer has operating inflows of $8,000,000, investing outflows of $3,000,000 and financing outflows of $4,500,000 for dividends and debt repayment. The net change is an increase of $500,000. The pattern is typical of a stable business that returns cash to its owners. Investors read the pattern as a sign of stability, though it also suggests limited growth opportunities for the business.
Formula
Calculation
Net change in cash = Cash flow from operations + Cash flow from investing + Cash flow from financing
Closing cash = Opening cash + Net change in cash
Worked example: a company has cash flow from operations of $600,000, cash flow from investing of negative $350,000 (it bought equipment) and cash flow from financing of negative $100,000 (it repaid a loan). Opening cash is $210,000.
Step 1: Net change = $600,000 - $350,000 - $100,000 = $150,000.
Step 2: Closing cash = $210,000 + $150,000 = $360,000.
The company ended the year with $360,000 in cash, up by $150,000.Case study
Seen in the real world
Sunvale Foods is an illustrative, fictional company that reported record profits of $2,000,000 but struggled to pay suppliers. The owner could not understand the problem until the accountant produced a cash flow statement. Operating cash flow was only $300,000 after a big rise in receivables and stock.
The statement also showed investing outflows of $900,000 for a new packing line. To fund the gap, the company had borrowed $800,000, so financing inflows were $800,000. The net change in cash was $300,000 - $900,000 + $800,000 = $200,000, but this relied entirely on the loan.
The illustrative lesson is that profit can hide a cash problem. The statement showed what the income statement could not: the business was growing faster than it could fund.
Watch out
Common mistakes
- Assuming a profitable company must have a healthy cash flow statement.
- Reading a negative investing figure as bad news, when it often means the company is investing for growth.
- Ignoring the split between operating, investing and financing, and looking only at the net change.
Questions
People also ask
Why does the cash flow statement matter if I have an income statement?
Profit includes non-cash items and timing differences, so only the cash flow statement shows the real movement of cash.
Which section is most important?
Many analysts focus on operating cash flow first, since it shows whether the core business generates cash. A company that is profitable but has weak operating cash flow deserves extra questions about receivables and stock.
Does the statement include credit sales?
Only when the customer pays, because it records cash and not invoices issued. This is why a business with large unpaid invoices can look profitable but still run short of money.
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