Cash Flow Statement: How to Read and Prepare One

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A cash flow statement (formally the statement of cash flows) reports how much cash a business took in and paid out over a period, sorted into three groups: operating, investing and financing activities. To read one, start with operating cash flow and compare it with net income, then see how the company spent on long-term assets and how it raised or returned capital. To prepare one, start from net income or from cash receipts and payments, adjust for balance sheet changes, and confirm that the net change in cash matches the change in the cash balance on the balance sheet.

What the cash flow statement tells you

The three core financial statements answer different questions. The income statement shows whether a company earned a profit. The balance sheet shows what it owns and owes on a given date. The cash flow statement connects them by explaining why the cash balance changed between two balance sheet dates.

That connection matters because accrual accounting records revenue when it is earned and expenses when they are incurred, not when money changes hands. A sale on 60-day credit terms counts as revenue immediately, though the cash comes later, and a machine bought for cash reaches the income statement only gradually, through depreciation. The cash flow statement strips out that timing and shows how much profit actually converted into cash: whether the business can pay suppliers, employees, lenders and tax authorities from what it generates.

The statement covers the same period as the income statement: a quarter or a fiscal year for published reports. Internal cash forecasts often run monthly or even weekly, because a shortfall can appear inside a quarter that looks fine in total.

The three sections of a cash flow statement

Operating activities

Operating activities are the cash effects of running the core business. Inflows include cash collected from customers. Outflows include payments to suppliers, wages, rent, utilities and income taxes. Under US GAAP, interest paid and interest and dividends received also fall here.

This section shows whether the company can fund itself from its own operations without new borrowing or share issues. Negative operating cash flow means the business is consuming cash, which may reflect a young company scaling up, poor working capital management, or a business in decline.

Investing activities

Investing activities cover cash spent on or received from long-term assets and investments. Outflows include capital expenditures (capex) on property, plant and equipment, purchases of securities, acquisitions of other businesses and loans made to others. Inflows include proceeds from selling assets or subsidiaries and collections of principal on loans the company made.

Heavy capex can signal expansion, but if operating cash flow does not support it, the spending can strain liquidity. A positive investing figure is not automatically good news: it often means the company sold assets, and repeated asset sales can be a way of raising cash the operations are not producing.

Financing activities

Financing activities record how a company raises and returns capital. Inflows come from issuing shares and borrowing. Outflows include repaying debt principal, paying dividends and buying back stock.

Borrowing to fund growth can be reasonable. Rising debt without matching growth in operating cash flow adds risk, because future interest and principal payments will compete with everything else for cash. Steady dividends and buybacks funded by operating cash flow, rather than by new debt, are generally read as a sign the business produces more cash than it needs.

Items that sit outside the three sections

Some transactions change the balance sheet without moving cash, such as buying equipment with a note payable, acquiring a company with shares, or converting debt into equity. These are disclosed separately as non-cash investing and financing activities rather than placed in any section. Classification of interest and dividends also differs by framework: US GAAP fixes it as described above, while IAS 7 has allowed companies some choice, which affects comparisons between a US GAAP filer and an IFRS filer.

Direct and indirect method

The two methods differ only in how operating cash flow is presented. Investing and financing sections look the same either way, and the net change in cash is identical.

The direct method lists actual operating cash receipts and payments: cash collected from customers, cash paid to suppliers, cash paid to employees, interest paid, taxes paid. It is easier for a reader to follow, but it requires tracking cash by category, which many accounting systems do not do by default. For example, if revenue was $900,000 and accounts receivable rose by $20,000 during the year, cash collected from customers was $880,000.

The indirect method starts with net income and works backward to cash:

1. Add back non-cash expenses such as depreciation, amortization, impairment charges and stock-based compensation.
2. Remove gains and add back losses on asset sales, because the full sale proceeds belong in investing activities.
3. Adjust for changes in working capital accounts.

The working capital adjustments follow a consistent rule:

• Increase in a current asset (receivables, inventory, prepaid expenses): subtract, because cash was tied up.
• Decrease in a current asset: add, because cash was released.
• Increase in a current liability (accounts payable, accrued expenses, taxes payable): add, because cash payment was deferred.
• Decrease in a current liability: subtract, because cash was paid out.

Both FASB and the IASB encourage the direct method, yet most companies use the indirect method because it draws on figures already in the income statement and balance sheet. Under US GAAP, a company that chooses the direct method must still include a reconciliation of net income to operating cash flow, which removes much of the saving in effort.

How to prepare a cash flow statement

1. Gather the inputs. You need the income statement for the period, balance sheets at the start and end of the period, and records of cash transactions such as bank statements and the general ledger.
2. Choose a method for the operating section.
3. Calculate operating cash flow. For the indirect method, begin with net income, add back non-cash items, adjust for gains and losses, then apply the working capital rules above. For the direct method, total cash collected and cash paid by category.
4. Calculate investing cash flow. Record capex and other purchases of long-term assets and investments as outflows, and sale proceeds and loan collections as inflows.
5. Calculate financing cash flow. Record proceeds from borrowing and share issues as inflows, and debt repayments, dividends and buybacks as outflows.
6. Reconcile. Add the three sections to get the net change in cash, add it to beginning cash, and confirm the result equals ending cash on the balance sheet. A mismatch usually means a balance sheet change was missed or put in the wrong section.
7. Disclose non-cash activities and, under US GAAP, interest and income taxes paid.

Cash flow statement example

The following is a hypothetical company for one fiscal year, prepared with the indirect method. Assume the equipment sold went for exactly its book value, so there is no gain or loss to adjust.

Cash flows from operating activities

• Net income: $120,000
• Depreciation: +$30,000
• Increase in accounts receivable: −$20,000
• Increase in inventory: −$15,000
• Increase in accounts payable: +$10,000
• Net cash from operating activities: $125,000

Cash flows from investing activities

• Purchase of equipment: −$80,000
• Proceeds from sale of equipment: +$5,000
• Net cash used in investing activities: −$75,000

Cash flows from financing activities

• Proceeds from bank loan: +$40,000
• Repayment of loan principal: −$25,000
• Dividends paid: −$30,000
• Net cash used in financing activities: −$15,000

Net increase in cash: $125,000 − $75,000 − $15,000 = $35,000 Beginning cash: $50,000 Ending cash: $85,000, which must match the cash line on the year-end balance sheet.

Several things stand out. Operating cash flow exceeds net income because depreciation is added back, but $35,000 of cash was absorbed by higher receivables and inventory, only partly offset by stretched payables. Free cash flow, commonly calculated as operating cash flow minus capex, is $125,000 − $80,000 = $45,000. The $30,000 dividend fits within that figure, so the company did not need its new loan to pay shareholders.

How to analyze a cash flow statement

Start with operating cash flow, then compare it with net income over several periods. Operating cash flow that consistently tracks or exceeds net income suggests reported earnings are turning into cash. A widening gap, where profit rises but operating cash flow does not, often traces back to receivables growing faster than sales or inventory building up.

Next, look at the investing section against operating cash flow. Can operations fund the capex, or does the company depend on financing for it? Free cash flow is the bridge between the two and is a core input in cash-based business valuation methods such as discounted cash flow.

Then read the financing section for direction and purpose. Is the company borrowing, issuing shares, paying down debt or returning cash? Financing that keeps filling a gap left by operations is a different situation from financing used to accelerate a business that already generates cash.

The signs of the three sections together often sketch a company’s stage. One textbook reading:

• Early-stage or rapid growth: operating negative or small, investing negative, financing positive.
• Established and self-funding: operating positive, investing negative, financing negative as the company repays debt or returns cash.
• Under pressure: operating shrinking or negative, investing positive from asset sales, financing positive as the company borrows to cover the shortfall.

These patterns are starting points, not verdicts. A single year can be distorted by an acquisition, a large tax payment or a seasonal swing in working capital.

Warning signs include declining or persistently negative operating cash flow, a high cash burn rate relative to the cash balance, and operating cash flow boosted mainly by delaying payments to suppliers, which cannot continue indefinitely.

Net income, cash flow and depreciation

A profitable company can still run out of cash. Customers may not have paid their invoices, inventory may have absorbed cash before it sells, or the company may have spent heavily on equipment or expansion. Strong reported earnings do not pay this month’s payroll if the cash is sitting in receivables.

Depreciation is added back in the indirect method because it reduces net income without any cash payment in the period. The cash left the business when the asset was bought and appeared then as capex in the investing section, so adding depreciation back prevents the same spending from reducing cash twice.

FAQs

The Bottom Line

Business owners, accountants and investors use the cash flow statement to see whether reported profit becomes cash the company can spend. Read operating cash flow against net income over several periods, check whether operations fund capex, and judge whether financing fills a gap or speeds up a self-funding business. Treat any single year with caution, since acquisitions, tax payments or seasonal working capital swings can distort it.