3.4 The Statement of Cash Flows

Learning Objectives

By the end of this section, you will be able to:

What the statement of cash flows measures

Three of the four financial statements answer questions about earnings, ownership, and position. This one answers a narrower question, and for a small business it is often the most urgent one: where did the money actually go?

Definition 3.4.1 - The statement of cash flows: three category subtotals, measured from a true zero, settling into one net change in cash.

At first glance a fourth statement can seem redundant. The income statement already reports inflows and outflows for a period. The statement of owner's equity and the balance sheet show other activities, such as investments by and distributions to owners, that the income statement leaves out. So why devote a whole statement to one asset?

The answer is accrual accounting. As §3.2.3 established, accrual accounting records revenues and expenses when they are earned or incurred, not when cash moves — and that creates timing differences between the income statement accounts and cash. A revenue transaction may be recorded in a different fiscal year than the year the related cash is received. The statement of cash flows exists so that users can see the actual amount of cash that came in and went out during the period, right alongside the revenue and expense figures on the income statement.

Most of that gap is timing differences between income statement accounts and cash receipts and distributions. Neither number is wrong. They are measuring different things, and the statement of cash flows is where the difference gets laid out line by line.

Three things this statement is good for

1. Seeing the actual cash movement. Cash flows often differ significantly from accrual-basis net income, and the statement is the only place the difference is spelled out.

2. Judging the quality of reported net income. A company whose statement of cash flows shows significantly less cash inflow than the net income reported on its income statement could very well be recognizing revenue for which cash will never actually be received from the customer, or underreporting expenses. That is a warning sign, and §3.5.4 returns to it.

3. Seeing sources and uses of cash unrelated to the income statement. In 2019 Amazon spent $287 million purchasing fixed assets and almost $370 million acquiring other businesses — telling statement users that the company was expanding even while losing money. Investors evidently agreed that this was good news, since Amazon raised more than $1 billion in borrowings and stock issuances that year. None of that activity appears on an income statement.

The statement answers two questions plainly: what are the sources of cash — where does the cash come from? And what are the uses of cash — where does it go? A positive net cash flow indicates an increase in cash during the reporting period; a negative net cash flow indicates a decrease. The statement is also used as a predictive tool, letting external users estimate future cash flows from past results.

Presentation of the statement is codified in U.S. GAAP under Topic 230, Statement of Cash Flows; accountants working internationally report under IAS 7. An ethical accountant understands who the users of a company's financial statements are and prepares the statement properly for them.

Two approaches to preparing it

The statement can be prepared using either of two approaches, and the difference shows up only in the operating activities section. Everything below the operating section looks identical either way.

Comparing the two methods. Both arrive at the same operating cash flow figure; they differ in what they show you along the way:

The one adjustment that trips up more owners than any other is depreciation, and it has a name.

Definition 3.4.3 - A noncash expense: depreciation lands in the income column and is stopped before the bank column.

Section 3.4.2 demonstrates the indirect method, since that is the one you will actually be handed. If a bookkeeper gives you a statement of cash flows, it will almost certainly begin with net income at the top — that is how you know which method you are looking at.

3.4.1 Operating, investing, and financing activities

Every cash flow on the statement is classified into exactly one of three categories. This is not filing for its own sake. The categories let a reader judge a company's strategy and its ability to generate a profit and stay in business, by showing how much the company leans on each source to produce its cash.

Operating activities

Definition 3.4.4 - Operating activities: cash in from customers, out to the six things the daily business consumes.

For a bookstore like Barnes & Noble, operating activities include buying and selling books and the multitude of other tasks the retail function requires. Operating cash flows include cash received from sales, and cash used to purchase inventory and to pay operating expenses such as salaries and utilities. They also include cash flows from interest and dividend revenue, interest expense, and income tax.

The net figure for the period — inflows compared to outflows — is presented as the cash generated from operating activities, and many decision makers view it as a good measure of a company's ability to prosper. Investors prefer to see a positive number that increases from year to year. Some analysts believe this figure reflects a company's financial health better than reported net income does, on the reasoning that the ultimate goal of a business is to generate cash.

No one could blame a decision maker for being puzzled by a pair of results like that. It is the clearest possible argument for reading all four statements rather than picking the one that answers fastest. A single year's net loss and a single year's strong operating cash flow are both facts, and the story that reconciles them is in the adjustments between them — which is what §3.4.2 walks through line by line.

Investing activities

Definition 3.4.5 - Investing activities: both purchases are assets, and only the second test separates them.

Two tests must both hold: the transaction involves an asset, and it is only tangentially related to the day-to-day running of the business. The contrast is easiest to see side by side.

Healthy, growing companies normally expect cash flows from investing activities to be negative — a net outflow — as management puts money into new noncurrent assets. Walgreen Co. spent over $1.2 billion in cash on property and equipment during the year ended August 31, 2011, part of a net of over $1.5 billion spent on investing activities. The company apparently had enough cash available to fund that expansion. Negative investing cash flow is what growth looks like on this statement.

Financing activities

Definition 3.4.6 - Financing activities: three movements touch only liabilities and equity, and none of them reaches net income.

Cash inflows from financing activities include issuing capital stock and incurring liabilities such as bonds or notes payable. Outflows are created by the distribution of dividends, the acquisition of treasury stock, the payment of noncurrent liabilities, and similar transactions.

For the year ended July 2, 2011, Sara Lee Corporation reported that its cash balance had been reduced by over $1.7 billion through financing activities — its three biggest movements being repayments of debt, purchases of common stock, and new borrowing. Significant information about management's decisions is readily apparent from an analysis of the cash flows from both investing and financing activities.

The net result for financing activities is frequently positive in some years and negative in others. When a company borrows money or sells capital stock, an overall positive inflow is likely. In years when a large dividend is distributed or debt is settled, the net figure is more likely to be negative.

Putting the three together

Two classification points cause most of the confusion for owners:

• A bank loan is a financing inflow, not revenue. It increases cash and never touches the income statement. This is the balance-sheet-side counterpart to the point made in §3.2.2.
• Owner draws are a financing outflow, not an expense. Money the owner takes out reduces cash and reduces equity, but it is not a cost of doing business and does not reduce net income.

Classification also has to be done correctly, because outsiders build calculations on it.

Definition 3.4.7 - Free cash flow: capital expenditures are carved off the operating cash flow, and only the remainder is free.

The capital expenditure figure normally comes from the investing section. So a transaction misfiled between sections can badly change an outside analyst's calculation, even when total net cash flow is unchanged. Picture a company that bought a warehouse in exchange for a $200,000 note payable and reported it as both a financing source and an investing use. The total at the bottom would be right, and the picture of how the business is funded would be wrong.

That is worth dwelling on before the practice below, because it is the difference between a bookkeeping slip and a misleading statement. The total at the bottom of the statement is the number an owner glances at, and it can be right while every category above it is wrong. A banker reading that statement is not glancing at the total — she is asking whether operations are funding the business or whether borrowing is, and that answer lives entirely in the classification. So the habit worth building is to ask two questions of every transaction: what kind of account did it touch, and was it part of running the business today? The example below is that pair of questions applied eight times.

3.4.2 Reconciling net income to net cash flow

This subsection answers the mechanical question: given that net income and cash are different numbers, how do you get from one to the other?

The logic of the indirect method

The indirect method follows the same set of procedures as the direct method, except that it begins with net income rather than with the business's entire income statement. From there, three moves convert accrual figures into cash figures:

1. Noncash items are removed.
2. Nonoperational gains and losses are removed.
3. Adjustments are made for the change during the period in the various balance sheet connector accounts, switching all remaining revenues and expenses from accrual accounting to cash accounting.

Step 1 — Start with net income

The operating activities cash flow is based on the company's net income, with adjustments for items that affect cash differently from the way they affect net income. For Propensity Company, net income for the year ended December 31, 2018 was $4,340, and that is the first line of the operating section.

Step 2 — Add back noncash expenses

Net income includes deductions for noncash expenses. To reconcile net income to cash flow from operating activities, these items must be added back, because no cash was actually spent on them.

Propensity's sole noncash expense is depreciation of $14,400. Depreciation reduced net income by $14,400 and reduced the bank account by nothing at all — so it is added back.

Step 3 — Remove nonoperational gains and losses

A gain or loss on selling an asset belongs to the investing section, not the operating section, so its effect on net income has to be reversed out. Propensity's gain on sale of plant assets of $4,800 is therefore subtracted in the operating section — the entire cash proceeds of the sale will appear under investing activities instead.

Step 4 — Adjust for changes in current assets and liabilities

Because the balance sheet and income statement reflect accrual accounting while the statement of cash flows considers actual cash transactions, there are continual differences between cash collected and paid on one hand, and reported revenue and expense on the other. The changes in current assets and liabilities can be read off the company's comparative balance sheet, which lists the current and previous period balances.

The reasoning is the same in every case: ask whether the change means cash moved differently from the way income was recorded. Working through a set of connector accounts for the Liberto example:

• Accounts receivable up $19,000. A rising receivable balance shows that less money was collected than the sales recorded during the period — customers were slow to pay. Cash is lower than income suggests. Subtract $19,000.
• Inventory down $12,000. A drop in inventory on hand indicates less merchandise was purchased during the period. Buying less requires paying less cash, leaving the balance higher. Add $12,000.
• Prepaid rent up $4,000. An increase in a prepaid expense shows more of the asset was acquired during the year than was consumed. That purchase used cash. Subtract $4,000.
• Accounts payable up. The business held onto its cash by not yet paying suppliers. Add.
• Salary payable down. The business paid off amounts owed to employees. Subtract.

The general rule. Every one of those five cases collapses into four lines worth memorizing:

The completed reconciliation

Assembling all of it for Propensity Company:

Net income of $4,340 became operating cash flow of $13,840 — more than three times larger — with no disagreement between the two statements. Both are correct. They measure different things.

Reading the result

Net cash flow from operating activities is the company's net income adjusted to reflect the cash impact of operating activities, and both the sign and the size of it carry meaning:

• Positive net cash flow generally indicates that adequate cash flow margins exist to provide continuity or ensure the survival of the company. A large figure suggests a comfortable cushion; a small one signals an uneasy zone.
• Substantially negative net cash flow from operations indicates the company's operations are not supporting themselves — a warning sign of possible impending failure.
• Slightly negative may serve as an early warning that lets management make corrections, ensuring that cash sources exceed cash uses in future periods.

For a small business owner, that last line is the useful one. A small negative operating cash flow is information you can still act on. Section 3.5.4 treats it as a red flag worth catching early.

3.4.3 Explaining why a profitable business can run out of cash

This is the question the whole chapter has been building toward, and it is the one a small business owner most needs to be able to answer.

Why the question is not a trick

Cash is required to pay the bills. Every business needs a clear picture of available cash so it can plan and pay. Some decision makers view the statement of cash flows as the most important of the four financial statements, because it shows how officials managed to get, and then use, the ultimate asset: cash. The acquisition of other assets, the payment of debts, and any distribution to owners all lead back to the company's ability to generate enough cash. This is why U.S. GAAP requires a statement of cash flows for every period in which an income statement is reported.

Michael Dell, founder of Dell Inc., put the failure mode plainly in Direct from Dell: "We were always focused on our profit and loss statement. But cash flow was not a regularly discussed topic. It was as if we were driving along, watching only the speedometer, when in fact we were running out of gas."

That is the entire lesson in one sentence. The income statement is the speedometer. It tells you how fast the business is going. It does not tell you how much fuel is left.

The mechanism, step by step

A business becomes profitable-but-broke through an ordinary sequence, and every step in it is correct accounting:

1. Revenue is recognized when earned, not when collected. The work is done in March, so March's income statement shows the revenue — whether or not the customer has paid.
2. The customer pays in 30, 60, or 90 days. Accounts receivable rise. As §3.4.2 showed, a rising receivable balance means less cash was collected than sales recorded — so operating cash flow falls below net income.
3. Growth makes it worse, not better. More sales means more receivables and more inventory purchased ahead of those sales. Both tie up cash. A business growing quickly can consume cash faster than a flat one.
4. Some large cash outflows never appear on the income statement. Buying equipment is an investing outflow; repaying loan principal is a financing outflow; an owner's draw is a financing outflow. All three reduce cash and none of them reduces net income.
5. Some large expenses involve no cash at all. Depreciation reduces net income without touching the bank account, so a business can report a loss while its cash holds steady — the Amazon case at the top of this section.

Put items 1 through 4 together and the result is routine: a profitable business, growing, collecting slowly, buying equipment and paying down a loan, that cannot make payroll.

A worked scenario

The sequence above is easier to believe once you watch it happen to a specific business over a specific three months. The example below is deliberately unremarkable — no fraud, no error, no unusual event. Every figure in it is what you would expect from a small service business having a good quarter and behaving sensibly: it invoiced its customers, it paid its bills, it bought a piece of equipment it needed, it made its loan payment, and its owner took a modest draw. Watch which of those five ordinary decisions shows up on the income statement, and which ones only ever show up in the bank balance. That gap is the whole phenomenon.

That diagnosis is the skill this section exists to build.

Cash flow as a going-concern signal

Because cash is what actually keeps a business alive, cash-based measures work as health indicators. Wall Street analysts lost faith in earnings-based metrics in the wake of Enron and WorldCom, and many moved toward the cash flow statement; companies are now regularly evaluated on free cash flow yield and other measures of cash generation. The operating cash flow ratio, the cash flow margin ratio, and related metrics let users analyze a company's ability to pay current debt and judge whether its operational cash flow can sustain it.

The same logic scales all the way down. A small business that is profitable every month and whose operating cash flow is persistently negative has a problem that the income statement will never report.

3.4.4 Why not all cash in a bank account belongs to the business: introducing trust fund liabilities

Section 3.4.3 explained why the cash you have can be less than the profit you earned. This subsection makes a sharper point about the cash you do have: some of it was never yours.

One account, two kinds of money

A bank statement reports a single number. That number is the sum of at least two categorically different things:

• Money the business earned. Revenue collected from customers, in exchange for goods or services the business provided. This belongs to the business, and it is available to spend.
• Money the business collected on someone else's behalf. Sales tax charged to customers, and income and payroll taxes withheld from employees' gross pay. This belongs to a government agency. The business is holding it until the remittance date.

The bank cannot tell these apart, and neither can the balance in a banking app. Only the balance sheet distinguishes them — and it does so by putting the second kind under liabilities, exactly as §3.3.4 described.

Now multiply that $4 across a whole quarter of sales. Then add every employee's withheld income tax and payroll taxes for the same period. The amount of other people's money sitting in a small business's operating account at any moment is routinely large.

Why this is called a trust fund liability

Definition 3.4.9 - A trust fund liability: one bank balance splits into money earned and money only being held.

The label captures the relationship accurately. The business collected it as an agent — from the customer at the register, from the employee at the payroll run — with an obligation to pass it along. The business is a conduit, and for the interval between collection and remittance it is holding funds that belong to someone else.

That is a meaningfully different obligation from an ordinary debt. A vendor bill is money the business owes because it made a promise. Withheld payroll tax is money the business owes because it is holding the employee's money, deducted from wages the employee already earned.

The consequence: your spendable cash is smaller than your balance

The practical rule follows directly:

The arithmetic is not hard, and that is the point worth making before you see it done. Nothing in this calculation requires accounting skill or software — it needs one figure off the balance sheet and one subtraction. What makes it a discipline rather than a formula is remembering to do it at all, on a day when the banking app is showing a comfortable number and a supplier is offering a deal that expires Friday. The example below is the whole habit: read the taxes-payable line, subtract it, and treat the result as the real balance.

Why the failure is so common

Three features make this a trap rather than a mistake anyone would obviously avoid:

1. The money arrives before the obligation is due. There is always a gap — often weeks or a full quarter — between collecting the tax and remitting it. During that gap the funds are genuinely in your account.
2. Nothing in the day-to-day flags it. Sales receipts, deposits, and the bank balance all report gross amounts. Only the balance sheet's liability section separates them out, and many owners look at the balance sheet far less often than the bank balance.
3. The shortfall is discovered late and all at once. The gap is invisible until the remittance date, by which point the money has usually been spent on something real — inventory, payroll, rent — that cannot be reversed.

The defense is entirely mechanical and does not require any accounting skill: know the balance sheet figure for taxes payable, and treat it as reducing available cash. Some businesses go further and hold collected tax in a separate account so the operating balance never overstates what is spendable.

What is at stake

Failing to remit collected trust fund money is not treated the same way as failing to pay an ordinary business debt. Because the funds were collected from third parties on a government agency's behalf, the consequences reach further — potentially past the business entity itself to the individuals responsible for the money, regardless of whether the business is an LLC or a corporation. That means the liability protection Chapter 1 established as the main advantage of those structures does not necessarily apply here.

That is a significant enough exception to entity-level liability protection to deserve its own treatment, and Chapter 5 gives it one, along with the specific federal and California filing and remittance requirements. For the purposes of reading a statement of cash flows, the point is narrower and is worth stating as plainly as possible:

Cash in the account is not the same as cash available. Some of what is there was collected for someone else, and the statement of cash flows counts it as cash while the balance sheet counts it as a liability. Both are correct — and only the second one tells you what you can spend.

Section 3.5 turns the three statements into a small set of ratios that make comparisons of this kind routine rather than occasional.

Problem Set 3.4

Key Terms