How to read a cash flow statement

What the statement shows that others do not

It reconciles profit with the real change in your bank balance, which the P&L and balance sheet do not do directly.

A business can report profit and still run out of cash, or lose money on paper and hold a healthy balance. The cash flow statement explains why. It starts with how much cash you had at the start of a period, adds and subtracts every category of cash movement, and arrives at the cash you have at the end.

It is the statement that shows whether the business can pay its bills, repay debt and fund growth from its own operations. If you need a refresher on the difference between earning and holding cash, read cash flow versus profit.

It also helps you explain your numbers. When someone asks why you borrowed even though you made money, the statement lets you point to the exact lines: receivables, inventory, equipment or debt payments.

Operating activities: the engine

The operating section shows cash generated by the day-to-day business, adjusted from net income for non-cash items and changes in working capital.

Most statements start with net income, then adjust it.

• Add back non-cash expenses such as depreciation, which reduced profit without any cash leaving.
• Subtract increases in receivables. If customers owe you more, you earned the sales but have not collected.
• Subtract increases in inventory. Stock bought is cash spent, not yet expensed.
• Add increases in payables. If you owe suppliers more, you kept cash longer.

Illustrative example: net income $20,000, plus depreciation $5,000, minus receivables up $12,000, minus inventory up $6,000, plus payables up $3,000, equals operating cash flow of $10,000. Profit was twice that. The difference is cash tied up in growth. Healthy businesses generate positive operating cash flow over time.

Investing activities: what you spent on the future

This section covers cash used to buy or sold from long-term assets such as equipment, vehicles, property or investments.

Buying a $30,000 truck is a cash outflow in investing, even though only a small part of it shows up as depreciation on the P&L. Selling old equipment for $4,000 is an inflow. Negative investing cash flow is normal and often good for a growing company, since it means you are spending on capacity.

The question is whether the purchase will pay for itself. The equipment payback period calculator helps you test it. For purchases you finance, see equipment financing.

Financing activities: debt and owner money

This section tracks loan proceeds, loan principal repayments, owner contributions, draws and distributions.

When you receive a $50,000 loan, financing cash flow rises by $50,000. When you repay $2,000 of principal in a month, it falls by that amount. Owner draws and distributions also appear here. Interest is usually included in operating activities under common U.S. accounting practice, though presentation can differ.

A pattern worth noticing: if operating cash flow is negative and financing is positive, you are using borrowed or invested money to run the business. That can be a deliberate bridge, but it should not become permanent. The guide to what goes on a cash flow statement lists the items in more detail.

Put the three sections together

Add the three sections to get net change in cash, then add it to opening cash to see ending cash.

Continue the example. Operating cash flow is $10,000. Investing is minus $30,000 for the truck. Financing is plus $30,000 of loan proceeds minus $3,000 of repayments, so plus $27,000. The net change is $10,000 minus $30,000 plus $27,000, or plus $7,000. If opening cash was $18,000, ending cash is $25,000.

Read the story rather than the arithmetic: the business made modest operating cash, bought a truck and funded most of it with a loan. Whether that was wise depends on how much new revenue the truck produces and whether operating cash flow can cover the loan payments.

Try the same exercise for your own last quarter. Write the three totals on one line, then write one sentence on what each means. Doing this a few times builds a feel for the way your business turns profit into cash, and where it leaks.

Ratios and red flags to check

Compare operating cash flow with net income, look at free cash flow and note any growing reliance on financing.

Three quick checks follow.

• Operating cash flow versus net income. If cash flow is consistently far lower than profit, look at receivables and inventory.
• Free cash flow. Operating cash flow minus capital spending. It shows what is left after maintaining and growing the asset base. See free cash flow.
• Debt service coverage. Can operating cash flow cover loan payments with room to spare?

If the numbers point to a timing gap rather than a structural problem, working capital or a line of credit may fit. Test the repayment against operating cash flow first, and use a stress test to see what happens if sales dip.