What it means
A business can be profitable and still run out of cash. The income statement counts sales when they are earned and costs when they are incurred, but the cash statement counts only money that actually moves in and out of the bank.
The statement is built around three sections. Operating activities cover day-to-day trading such as customer receipts and payments to suppliers and staff, investing activities cover buying and selling long-term assets, and financing activities cover borrowing, repaying debt, issuing shares and paying dividends.
There are two ways to prepare the operating section. The direct method lists cash received and cash paid, while the indirect method starts with net profit and adjusts for non-cash items such as depreciation and for changes in working capital.
Most companies use the indirect method because it reconciles profit with cash. Finance teams use the statement to judge liquidity, test whether growth is being funded sustainably and see whether profit is turning into cash.
Lenders look at it closely, and so do managers who want to know why the bank balance is not rising when sales are. The nuance is that a negative number is not always bad.
A fast-growing company may show negative operating cash flow because it is building inventory, and a company investing heavily in new equipment will show negative investing cash flow, which is usually a sign of expansion. Reading the statement well means looking at the relationships between the three sections and not at each number in isolation.
Healthy mature businesses usually show strong positive operating cash flow, moderate negative investing cash flow and negative financing cash flow as they repay debt and pay owners. A business that relies on new borrowing every year to cover operating shortfalls is sending a very different message.
In practice
Real-world examples.
Example
A subscription software company reports a net profit of $600,000 but operating cash flow of $900,000 because customers pay annual fees in advance. The cash flow statement shows how deferred revenue is boosting cash above profit.
Example
A building contractor reports a profit of $300,000 while its operating cash flow is -$80,000. The statement shows that receivables grew by $500,000 as clients delayed payment, so the firm needs a credit line to pay wages.
Example
A start-up raises $2,000,000 from investors and spends $1,500,000 on running costs. The statement shows a financing inflow of $2,000,000 and an operating outflow of -$1,500,000, helping the founders see their runway at a glance.
Formula
Calculation
Net change in cash = operating cash flow + investing cash flow + financing cash flow
A retail company starts the year with $200,000 in the bank. It generates $450,000 from operating activities, spends $300,000 on new shop fittings and equipment, which is an investing outflow of -$300,000, and repays $100,000 of bank borrowing while paying $40,000 in dividends, which is a financing outflow of -$140,000.
Net change in cash = 450,000 - 300,000 - 140,000 = $10,000. Closing cash = 200,000 + 10,000 = $210,000. The statement shows the company grew its cash only slightly even though operations generated $450,000.Case study
Seen in the real world.
Oakhaven Foods is an illustrative, fictional producer of packaged sauces that grew sales by 40% in a single year. The owner was puzzled when the bank balance fell, because the income statement showed record profit.
The finance manager prepared a cash flow statement using the indirect method. It showed that profit of $500,000 was more than absorbed by a $350,000 increase in inventory and a $400,000 increase in unpaid customer invoices.
Armed with that picture, the company negotiated shorter payment terms with its largest customers and trimmed stock levels. Within two quarters operating cash flow turned positive. The illustrative point is that fast growth can consume cash, and only the cash flow statement makes that visible.
Watch out
Common mistakes.
- Assuming that profit and cash flow should match, when timing differences between earning and collecting can make them very different.
- Treating depreciation as a cash cost, when it is a non-cash charge that is added back in the indirect method.
- Reading negative investing cash flow as a problem, when it often means the business is spending on future growth.
Questions
People also ask.
Which method should I use, direct or indirect?
Most businesses use the indirect method because it links directly to the income statement and balance sheet, though the direct method can be more intuitive.
Where does interest paid appear?
It depends on the accounting standard and the company's policy, so it may appear under operating or financing, and it should be shown consistently.
Why does the closing cash have to match the balance sheet?
Because the statement explains the change in cash, so the closing figure must equal the cash line on the balance sheet.
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