What it means
The income statement records revenue when it is earned and expenses when they are incurred, not when money changes hands. A company can report a healthy profit while its customers have not paid, its inventory is piling up and its bank balance is shrinking.
The cash flow statement reconciles profit to the change in cash, exposing exactly that kind of gap. It has three sections.
Operating activities show cash generated by the core business: cash received from customers minus cash paid to suppliers, staff, landlords and the tax authority. Under the indirect method, which most companies use, this section starts with net profit, adds back non-cash charges such as depreciation, and then adjusts for changes in working capital (receivables, inventory, payables).
Investing activities show cash spent on long-term assets such as equipment, property and acquisitions, and cash received from selling them. Financing activities show cash raised from or returned to lenders and shareholders: new loans, repayments, share issues, dividends and buybacks.
The pattern across the three sections tells a story. A mature, healthy business typically shows strong positive operating cash flow, moderate negative investing cash flow (it keeps reinvesting) and negative financing cash flow (it repays debt and pays dividends).
A fast-growing start-up shows negative operating cash flow funded by positive financing cash flow. A company in trouble may show weak operating cash flow propped up by selling assets, which appears as positive investing cash flow.
The single most useful derived figure is free cash flow: operating cash flow minus capital expenditure. It is the cash left over after keeping the business running and equipped, available to repay debt, pay owners or fund growth.
In practice
Real-world examples.
Example
A software subscription business shows operating cash flow well above profit because customers pay a year in advance and the revenue is recognised monthly.
Example
A construction firm shows a profit but negative operating cash flow because it has to pay subcontractors long before its clients pay it.
Example
A retailer shows positive investing cash flow for a year because it sold and leased back its store properties, a warning sign that it is converting assets to cash rather than generating it from trading.
Formula
Calculation
Net change in cash = Cash from operating activities + Cash from investing activities + Cash from financing activities
Operating cash flow (indirect method) = Net profit + Depreciation and other non-cash items minus Increase in receivables minus Increase in inventory + Increase in payables
Worked example. A distribution company reports the following for the year:
- Net profit: $400,000
- Depreciation: $150,000
- Accounts receivable rose by $220,000 (customers took longer to pay)
- Inventory rose by $90,000
- Accounts payable rose by $60,000
- Purchase of new delivery vans: $300,000
- New bank loan: $200,000
- Dividends paid: $100,000
Operating cash flow = $400,000 + $150,000 minus $220,000 minus $90,000 + $60,000 = $300,000
Investing cash flow = minus $300,000
Financing cash flow = $200,000 minus $100,000 = $100,000
Net change in cash = $300,000 minus $300,000 + $100,000 = $100,000
The company made $400,000 of profit but only $300,000 of operating cash, because $250,000 was absorbed into receivables and inventory. Free cash flow was $0 ($300,000 minus $300,000 of vans), so the dividend was effectively paid with borrowed money.Case study
Seen in the real world.
A furniture manufacturer had reported five consecutive years of rising profit, and its owner was surprised when the bank declined to extend its overdraft. The bank's analyst had read the cash flow statements. Operating cash flow had been below profit every year, and negative in two of them, because receivables had grown from 45 days of sales to 95 days as the company chased volume by offering generous credit to large retail chains.
Meanwhile capital expenditure had doubled to add capacity. The gap had been funded entirely by the overdraft, which had grown from $200,000 to $1.4 million. The company was profitable and insolvent at the same time.
The turnaround plan focused on cash: tightening credit terms, factoring the largest receivables and pausing expansion. Operating cash flow turned positive within two quarters, and the bank restored the facility once it saw cash, not profit, improving.
Watch out
Common mistakes.
- Judging a business on profit alone. Profit is an opinion; cash is a fact. Read both.
- Ignoring the working capital lines. A rise in receivables or inventory is cash going out of the door, however healthy the sales figure looks.
- Treating positive investing cash flow as good news. It usually means assets are being sold.
Questions
People also ask.
What is the difference between the direct and indirect methods?
Both give the same operating cash flow. The direct method lists cash receipts and payments; the indirect method starts from profit and adjusts. Most companies use the indirect method.
Where does interest paid appear?
Under IFRS companies may classify it as operating or financing; under US GAAP it is operating. Check the policy note when comparing companies.
What is free cash flow?
Operating cash flow minus capital expenditure: the cash available after keeping the business running and equipped.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%