The cash flow statement

In simple terms

The cash flow statement shows the money that actually came into and went out of a company during a period. Unlike the income statement, which follows accrual accounting, it records cash when it moves. Its last line is the change in cash, which matches the change in cash between two balance sheets.

It groups every movement of cash into three sections:

Where interest and dividends received or paid appear can vary between companies, so check the company's accounting policies before comparing.

From profit to operating cash flow

Most companies present operating cash flow using the indirect method. It starts with profit and makes three kinds of adjustment:

1. Add back non-cash costs, such as depreciation, amortisation and impairments, which reduced profit without using cash.
2. Remove non-operating items, such as interest paid (shown under financing) and gains on selling assets (whose cash proceeds appear under investing).
3. Adjust for working capital. An increase in receivables or inventory used cash, so it is subtracted; an increase in payables kept cash in the business, so it is added. Decreases work the other way.

Finally, the tax actually paid is subtracted.

Worked example

Free cash flow

Free cash flow is the cash a business produces after the capital expenditure needed to keep it running and growing:

For Kaveri Pumps: 150 − 120 = ₹30 crore. That is the cash available for paying debt, dividends, buybacks or acquisitions without borrowing. The land sale is left out because it will not repeat. Free cash flow is covered in depth in the fundamental analysis path.

Reading the patterns

The signs of the three sections, over several years, often describe a company's situation:

These are starting points for questions, not conclusions. A single year can mislead, for example in a year with an unusually large acquisition.

Why it matters

Cash is harder to dress up than profit, because it has to be in the bank. Comparing net cash from operating activities with net profit over five years or more is one of the best tests of earnings quality: in a healthy business the two should broadly track each other. A company that keeps reporting profits while operating cash flow stays weak or negative deserves close scrutiny, as the profit compared with cash flow lesson explained.

Limitations

• Timing can flatter operating cash flow. Delaying payments to suppliers, selling receivables to a financing company, or running down inventory before the year end all lift it temporarily.
• Classification choices move items between sections, for example whether interest paid sits in operating or financing activities.
• One year is noisy. Large orders, seasonal stock-building and acquisitions make single years unrepresentative.
• The simple free cash flow formula does not separate spending that maintains the business from spending that grows it.

Common mistakes

• Assuming positive total cash flow means a healthy year. A company can increase its cash by borrowing heavily.
• Ignoring investing cash flows. A business with strong operating cash flow that must spend all of it on equipment has little free cash.
• Subtracting increases in payables. An increase in payables means suppliers were paid later, which kept cash in the business.
• Counting one-off asset sales as recurring cash.

Try it yourself

1. Open the cash flow statement in a listed company's annual report.
2. Write down net cash from operating, investing and financing activities for the last two years.
3. Compare net cash from operating activities with net profit for each year. Is it higher or lower, and which working capital lines explain the difference?
4. Calculate free cash flow as operating cash flow minus "purchase of property, plant and equipment".