The statement of cash flows
Profit is not the same as cash. The statement of cash flows shows where cash came from and where it went.
Purpose
The statement of cash flows reports cash receipts and payments during a period, explaining the change in cash on the balance sheet. It shows whether a business generates enough cash to operate, invest, and repay debts, which profit alone cannot show.
Operating activities
Operating activities are the main revenue-producing activities: cash received from customers and paid to suppliers, employees, and for interest and taxes (under US GAAP, interest paid is operating). Positive operating cash flow over time is a sign of a healthy business.
Investing activities
Investing activities involve buying and selling long-term assets and investments: purchasing equipment or buildings, selling old equipment, buying or selling securities of other companies, and making or collecting loans. Growing companies often have negative investing cash flows as they invest.
Financing activities
Financing activities involve owners and lenders: issuing shares, buying back shares, borrowing, repaying loans, and paying dividends (under US GAAP, dividends paid are financing). They show how a business funds itself.
Direct and indirect methods
Operating cash flow can be presented by the direct method, listing actual cash receipts and payments, or the indirect method, which starts with net income and adjusts for non-cash items (adding back depreciation) and changes in working capital. Most companies use the indirect method.
Indirect method adjustments
In the indirect method, increases in current assets such as receivables and inventory are subtracted (cash tied up); decreases are added. Increases in current liabilities such as accounts payable are added (cash not yet paid); decreases are subtracted. Depreciation is added back because it reduced net income without using cash.
Free cash flow
Free cash flow is operating cash flow minus capital expenditures. It shows cash available to repay debt, pay dividends, or invest further. Investors watch it closely because it is harder to manipulate than earnings.
Worked example
A company reports net income of 100,000 dollars, depreciation of 30,000, an increase in accounts receivable of 20,000, and an increase in accounts payable of 10,000. Operating cash flow (indirect method) = 100,000 + 30,000 - 20,000 + 10,000 = 120,000. If capital expenditures are 50,000, free cash flow is 70,000.
Key takeaways
The statement of cash flows explains the change in cash. Operating activities are core business cash flows; investing activities involve long-term assets; financing activities involve owners and lenders. The indirect method starts with net income, adds back depreciation, and adjusts for working capital changes. Increases in current assets reduce cash; increases in current liabilities increase it. Free cash flow equals operating cash flow minus capital expenditures.
Flashcard
Explains change in cash
Check your understanding
Under the indirect method, why is depreciation added back to net income?