Reading a cash flow statement

The income statement tells you whether a business made a profit. The balance sheet tells you what it owns and owes on one day. The cash flow statement tells you where the cash actually came from and went over the period. For anyone running or analysing a business, it is often the most revealing of the three, because cash is hard to dress up.

The three sections

Under international standards (IAS 7) and US rules alike, the statement sorts cash movements into three groups.

• Operating activities. Cash from the core business: customers paying, and suppliers, staff, rent and taxes being paid.
• Investing activities. Cash spent on or received from long-term assets: equipment, property, software development, acquisitions and investments.
• Financing activities. Cash from or returned to owners and lenders: issuing shares, borrowing, repaying loans, buying back shares and paying dividends.

The three totals add up to the net change in cash for the period, which should match the movement in cash on the balance sheet.

Why profit and cash differ

Profit is calculated on an accruals basis: revenue is counted when earned and costs when incurred, not when cash changes hands. That creates gaps:

• Non-cash costs. Depreciation and amortisation reduce profit but involve no cash payment in the year.
• Receivables. If customers owe you more at the end of the year than at the start, you have recorded sales you have not yet been paid for.
• Inventory. Buying stock uses cash before it becomes a cost of sale.
• Payables. If you owe suppliers more than before, you have kept cash that you will later pay out.

Direct and indirect methods

Operating cash flow can be shown two ways. The direct method lists cash received from customers and paid to suppliers and staff. The indirect method, which most companies use, starts from net profit and adjusts it: adding back non-cash items such as depreciation, then adjusting for changes in receivables, inventory and payables. IAS 7 encourages the direct method but allows either.

A simple example (illustration only)

The figures below are invented to show the structure, using the indirect method.

The business made £200,000 profit but generated only £120,000 from operations, mainly because customers took longer to pay. Free cash flow, operating cash flow minus capital spending, was £30,000.

Questions to ask when reading one

1. Is operating cash flow positive, and how does it compare with profit? Over several years, a healthy business usually turns most of its profit into cash. A persistent gap deserves an explanation.
2. What is happening to working capital? Rising receivables can mean growth, or customers paying slowly. Rising inventory can mean preparation for demand, or stock that is not selling.
3. How much is spent on capital expenditure? Compare it with depreciation. Spending well below depreciation for years may mean assets are being run down.
4. What is the free cash flow? This is the cash available to repay debt, pay dividends or invest further.
5. What is financing paying for? Borrowing to fund growth is different from borrowing to cover operating losses or to keep paying dividends.

Patterns worth recognising

• Young, growing company: negative operating and investing cash flow, funded by investors or loans.
• Mature, steady company: positive operating cash flow, moderate investing outflows, financing outflows from dividends and debt repayment.
• Warning sign: reported profits rising while operating cash flow falls for several years.

Using it in a small business

You do not need to be a listed company to benefit. Most accounting software can produce a cash flow statement each month. Read it alongside your bank balance and ask the same questions: did the business generate cash from trading, what did we spend on equipment, and did we rely on loans or the owners’ money to cover the gap? A simple monthly cash forecast, built in the same three sections, gives early warning of a shortfall while there is still time to act, such as chasing overdue invoices or delaying a purchase.

Where to practise

Annual reports from listed companies are free on their investor relations pages and on regulators’ sites. Read three years side by side. Patterns appear quickly once you know where to look, and the cash flow statement often answers questions the income statement raises.