What it means
The cash flow statement splits every movement of cash into three buckets: operating, investing and financing. Investing covers buying and selling long-term assets, financing covers raising and repaying capital, and operating covers everything else that relates to trading.
The split matters because cash from selling a factory is not the same quality of cash as cash from selling products. Most companies present the operating section using the indirect method, which starts with profit and works back to cash.
The adjustments fall into two groups: non-cash items such as depreciation, amortisation and share-based payments, and movements in working capital such as receivables, inventory and payables. The direct method, which simply lists cash received and cash paid, is permitted but rarely used in practice.
Working capital movements are where the useful information hides. A growing business that lets receivables balloon can be profitable and still run out of money, while a business that stretches its suppliers can show strong operating cash that is really just borrowing from them.
Reading three years of these lines together tells you whether the pattern is deliberate or drifting. Classification is not entirely uniform across companies.
Interest paid and dividends received can sit in either the operating or the financing section depending on the framework and the policy chosen, and tax is normally in operating unless it clearly relates to an investing or financing transaction. When comparing two companies, check their accounting policies before assuming the totals are equivalent.
The headline number, usually called cash from operations or operating cash flow, is the starting point for free cash flow and for many lending covenants. Comparing it with net profit over several years is one of the simplest tests of earnings quality, because if profit consistently exceeds operating cash then something is being recognised faster than it is being collected.
That gap is worth understanding before anything else in the accounts.
In practice
Real-world examples.
Example
A subscription software firm bills annually in advance, so cash arrives before revenue is recognised. It reports net profit of $1,200,000 but cash from operating activities of $2,100,000, the difference sitting in the rise in deferred income.
Example
A construction contractor reports net profit of $800,000 with depreciation of $300,000, but receivables and retentions rise by $1,300,000. Operating activities produce negative $200,000, so the company draws on its overdraft despite a profitable year.
Example
A homewares retailer builds $4,000,000 of stock ahead of the Christmas season. Its operating cash flow is heavily negative in the autumn quarter and strongly positive in the winter one, which is why only the full year figure is meaningful.
Formula
Calculation
Under the indirect method:
Cash from operating activities = net profit + non-cash charges - increases in working capital + decreases in working capital
A distribution business reports the following for the year:
Net profit: $420,000
Add back depreciation: $180,000
Increase in receivables: -$120,000
Decrease in inventory: +$40,000
Increase in payables: +$60,000
Cash from operating activities = $420,000 + $180,000 - $120,000 + $40,000 + $60,000 = $580,000.
The business turned $420,000 of profit into $580,000 of cash, largely because depreciation is a real expense that never left the bank account. Had receivables risen by $320,000 rather than $120,000, operating cash would have been $380,000, below reported profit, and the growth would have been consuming cash instead of producing it.Case study
Seen in the real world.
This is an illustrative example featuring a fictional business. Alder Rail Components grew revenue 40% in a year, from $20,000,000 to $28,000,000, and reported net profit of $1,600,000 with depreciation of $700,000. The sales director was celebrating.
The cash flow statement told a different story. Receivables rose $2,400,000, inventory rose $1,100,000 and payables rose only $500,000, so cash from operating activities was $1,600,000 + $700,000 - $2,400,000 - $1,100,000 + $500,000 = negative $700,000. Profitable growth had consumed cash rather than generating it, and the overdraft was close to its limit.
The finance director focused on collections rather than on sales. Bringing debtor days down from 74 to 52 on the same revenue released roughly $1,700,000 of cash, which was enough to clear the overdraft and fund the following year's stock build. Nothing about the profit figure changed; only the timing of the cash did.
Watch out
Common mistakes.
- Reading only the bottom line of the cash flow statement, which mixes trading cash with new borrowings and asset sales.
- Celebrating strong operating cash that was produced by stretching suppliers, since payables cannot keep rising indefinitely.
- Assuming depreciation is a source of cash, when it is added back only because it was deducted from profit without any money leaving the business.
Questions
People also ask.
Is interest paid an operating or a financing item?
It depends on the reporting framework and the policy chosen, so check the accounting policies note before comparing two companies line by line.
Why do profitable companies run out of cash?
Because growth ties money up in receivables and inventory faster than trading generates it, which shows up as a large negative working capital movement inside operating activities.
What is a healthy relationship between profit and operating cash?
Over several years operating cash should be at least as large as net profit for most businesses, because depreciation is added back, so a persistent shortfall is a signal to investigate.
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