What is a cash flow statement?

The income statement records revenue when it is earned and costs when they are incurred, whether or not money has changed hands. The balance sheet is a snapshot on one date. The cash flow statement covers the same period as the income statement but counts only cash: money received from customers, paid to suppliers and staff, spent on equipment, borrowed, repaid and returned to shareholders. In the words of the SEC’s beginners’ guide, the income statement tells you whether a company made a profit, while the cash flow statement tells you whether it generated cash.

Every line has a sign. A positive number is cash coming in; a negative number, often shown in parentheses, is cash going out. The three section totals add up to the net change in cash, which must match the change in cash between the opening and closing balance sheets.

Cash flow statement
The financial statement that reports a company’s cash inflows and outflows over a period, split into operating, investing and financing activities, ending with the net change in cash.
Cash and cash equivalents
Cash on hand and in bank accounts plus short-term, highly liquid investments that can be turned into a known amount of cash with little risk of a change in value.

The three sections: operating, investing and financing

Each section answers a different question, and together they show where the money came from and where it went. Companies that report under international rules (IFRS) have had some choice in where to place interest and dividends, so read the notes before comparing a US company with a foreign one.

  • Operating activities: does the core business bring in cash? Cash from customers minus cash paid to suppliers, employees, landlords and the tax authorities. Under US rules, interest paid and received and dividends received usually sit here too.
  • Investing activities: what is the company spending on its future, and what is it selling? Capital expenditures (capex) on buildings, equipment and software, acquisitions of other businesses, and purchases and sales of investment securities.
  • Financing activities: how does the company deal with the people who fund it? New borrowing and debt repayments, shares issued, stock buybacks and dividends paid.
Cash flow from operating activities (CFO)
The cash a company’s core business generated or used during the period, after paying suppliers, staff, interest and taxes. Also called operating cash flow.
Cash flow from investing activities
Cash spent on or received from long-term assets and investments: capital expenditures, acquisitions, and purchases and sales of securities.
Cash flow from financing activities
Cash exchanged with lenders and shareholders: borrowing and repaying debt, issuing shares, buying back shares and paying dividends.

A worked example: XYZ’s cash flow statement, line by line

Here is hypothetical XYZ’s statement for one year, in millions of dollars, as in the drawing below. Each section total is the sum of the lines above it:

  1. Operating: net income 200 + depreciation and amortization 60 + stock-based compensation 20 − increase in receivables 30 − increase in inventory 20 + increase in payables 10 = 240.
  2. Investing: capital expenditures −90, acquisition of a small business −40, sale of investments +10 = −120.
  3. Financing: new borrowing +50, debt repaid −80, dividends paid −40, shares bought back −30 = −100.
  4. Net change in cash: 240 − 120 − 100 = +20.
  5. Check against the balance sheet: cash of 150 at the start of the year + 20 = 170 at the end, the figure the closing balance sheet should show.

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Three cards for hypothetical XYZ’s cash flow statement, in $ millions. Operating: net income +200, depreciation +60, stock pay +20, more receivables −30, more inventory −20, more payables +10, total +240 in green. Investing: capex −90, acquisition −40, investments sold +10, total −120 in red. Financing: new borrowing +50, debt repaid −80, dividends −40, buybacks −30, total −100 in red. A note reads net change in cash: 240 − 120 − 100 = +20; cash 150 → 170.

From net income to operating cash flow: the indirect method

Most companies start the operating section from net income and adjust it, which is called the indirect method; a few list the cash received and paid directly. The adjustments fall into two groups. Non-cash items are added back: depreciation and amortization spread the cost of past purchases over time and use no cash this year, and stock-based compensation is paid in shares, not cash. Changes in working capital come next. If receivables grow, customers owe more and the company has collected less cash than it booked as sales. If inventory grows, cash is tied up on the shelves. If payables grow, the company is paying its suppliers later and keeps the cash for now.

In the drawing below, XYZ’s 200 of net income becomes 240 of operating cash: +60 depreciation, +20 stock pay, −30 receivables, −20 inventory and +10 payables. A rule of thumb: an increase in an asset other than cash reduces operating cash flow, and an increase in a liability adds to it.

Indirect method
The usual way of presenting operating cash flow: start from net income, add back non-cash items such as depreciation, and adjust for changes in receivables, inventory, payables and other working capital.
Change in working capital
The movement in short-term operating assets and liabilities, such as receivables, inventory and payables, during the period. A build-up of receivables or inventory uses cash; a rise in payables frees it.

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A waterfall from net income to operating cash flow for hypothetical XYZ, in $ millions, on an axis starting at 150: net income 200 in gray, green steps up of +60 depreciation and +20 stock pay, red steps down of −30 more receivables and −20 more inventory, a green step of +10 more payables, and operating cash flow 240 in gray. A note reads more of an asset other than cash: less cash; more of a liability: more cash.

Free cash flow, and what the cash paid for

Free cash flow (FCF), as commonly calculated, is operating cash flow minus capital expenditures: 240 − 90 = 150 for XYZ. It is the cash left after keeping the business running and growing, before acquisitions, debt payments and payouts to shareholders. XYZ paid 40 in dividends and 30 in buybacks, 70 in all, less than half of its FCF. New borrowing of 50 and the rest of its FCF went to the acquisition, to repaying 80 of debt and to the 20 added to cash.

Accounting rules do not define free cash flow, so companies calculate it differently: some subtract only part of their capex, others leave out lease payments. Recalculate it yourself from the statement. The free cash flow lesson covers FCF margin, FCF yield and the stock-based compensation caveat: XYZ’s 240 includes 20 of stock pay added back, so its FCF after stock pay would be 130.

Capital expenditures (capex)
Cash spent on long-term physical and digital assets such as buildings, machinery, equipment and software. Shown in the investing section, usually as purchases of property and equipment.

What the pattern of signs tells you

The signs of the three totals give a quick sketch of a company’s situation. The drawing below shows four hypothetical profiles. They are common shapes, not rules, so confirm them in the numbers and the notes:

  • Mature and self-funding (+ − −): operations bring in cash, which pays for investment, dividends, buybacks or debt repayment. XYZ fits this pattern.
  • Young and growing (− − +): operations use cash, investment continues, and new shares or loans fill the gap. It lasts only as long as investors and lenders keep providing money; watch for stock dilution.
  • Growing with outside money (+ − +): operations bring in cash, but investment is larger, so the company also borrows or issues shares.
  • Under strain (− + +): operations use cash, and the company sells assets and borrows to cover it. One year can have an explanation; several in a row deserve a close look.

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Four cards, each with the signs of operating, investing and financing cash flow in circles, green for + and red for −. Mature, self-funding: + − −, marked like XYZ. Young, growing: − − +. Growing with outside money: + − +. Under strain: − + +. A note reads common shapes, not rules: confirm them in the numbers.

Red flags on the cash flow statement

Read three to five years side by side, and compare operating cash flow with net income each year. These patterns deserve a closer look:

  • Net income rising while operating cash flow stalls or falls, often because receivables or inventory grow faster than sales.
  • Operating cash flow propped up by paying suppliers later and later, which cannot go on forever.
  • Dividends and buybacks larger than free cash flow year after year, paid for with new debt.
  • Growth bought through repeated acquisitions: they sit outside capex, so FCF can look healthy while cash keeps leaving for deals.
  • Large one-off inflows, such as selling a business or a building, that flatter the net change in cash; they appear under investing, not operating, activities.
  • Stock-based compensation that makes up a large share of operating cash flow.