The Statement of Cash Flows (SCF) shows how cash moves in and out of a company over a period (e.g., a quarter or year). It explains the change in the cash balance reported on the balance sheet.
Unlike the income statement (which uses accrual accounting), the SCF focuses on actual cash transactions.
Income Statement
Revenue is recognized when earned, even if cash hasn't been received
Statement of Cash Flows
Cash is recorded only when it is received or paid
Accrual vs. Cash
A company sells $10,000 of goods on credit in Q1.
- Income Statement: Records $10,000 revenue in Q1
- Cash Flow Statement: $0 cash from operations in Q1
- When the customer pays in Q2, the SCF records the $10,000 as cash received
The four core financial statements are interconnected:
Balance Sheet
Snapshot of assets, liabilities, and equity at a point in time
Income Statement
Profitability over a period
Statement of Cash Flows
Explains the change in cash
Statement of Shareholders' Equity
Tracks changes in equity (e.g., retained earnings, stock issuance)
HOW ACCRUAL ACCOUNTING CONNECTS THE STATEMENTS
Net income Change in cash. Why? Because accrual accounting recognizes revenue and expenses when they occur, not when cash moves.
These timing differences create changes in working capital accounts, which link the income statement to the cash flow statement:
Accounts Receivable ↑
Revenue earned but cash not yet received
Accounts Payable ↑
Expense incurred but cash not yet paid
Unearned Revenue ↑
Cash received before revenue is earned
Beginning Cash + Net Cash Inflows = Ending Cash
Operating activities are the core revenue-generating activities of a business (e.g., selling goods, paying suppliers).
There are two methods to present CFO:
THE INDIRECT METHOD (MOST COMMON)
Starts with net income and adjusts for non-cash items and changes in working capital.
2
ADD BACK NON-CASH EXPENSES
- Depreciation & Amortization
- Losses on asset sales
3
SUBTRACT GAINS ON ASSET SALES
4
ADJUST FOR CHANGES IN WORKING CAPITAL
- Accounts Receivable Subtract (cash not received)
- Inventory Subtract (cash tied up)
- Accounts Payable Add (cash not yet paid)
THE DIRECT METHOD
Shows actual cash inflows and outflows from operations.
Cash received from customers
Cash paid to suppliers
Cash paid to employees
Cash paid for interest and taxes
Note: U.S. GAAP and IFRS require the indirect method to be disclosed even if the direct method is used.
CALCULATING DIRECT METHOD ITEMS
To convert accrual data to cash, use related balance sheet accounts.
1. Cash Received from Customers
Cash Received = Revenue ΔAccounts Receivable
Example
Revenue = $500,000, A/R by $20,000.
Cash Received = $500,000 $20,000 = $480,000
2. Cash Paid for Inventory
Step 1: Calculate Purchases
Purchases = COGS + ΔInventory
Step 2: Calculate Cash Paid
Cash Paid = Purchases ΔAccounts Payable
Example
COGS = $300,000, Inventory $10,000 Purchases = $310,000
A/P $5,000 Cash Paid = $310,000 (−$5,000) = $315,000
3. Cash Paid to Employees
Cash Paid = Salaries Expense ΔSalaries Payable
4. Cash Paid for Interest
Cash Paid = Interest Expense ΔInterest Payable
CONVERTING INDIRECT TO DIRECT METHOD
-
1.
Start with accrual income statement items (e.g., revenue, COGS)
-
2.
Remove non-cash components (e.g., depreciation)
-
3.
Adjust for changes in related balance sheet accounts to get cash flows
Investing activities involve long-term assets and investments.
Cash Inflows
- Sale of property, plant, and equipment (PPE)
- Sale of investments (stocks, bonds)
Cash Outflows
- Purchase of PPE
- Purchase of investments
Net CFI = Proceeds from Asset Sales Purchases of Long-Term Assets
Example
A company sells old equipment for $50,000 and buys new machinery for $200,000.
Net CFI = $50,000 $200,000 = −$150,000
Financing activities involve transactions with owners and creditors.
Cash Inflows
- Issuing debt (bonds, loans)
- Issuing common stock
Cash Outflows
- Repaying debt (principal)
- Paying dividends
- Buying back stock (treasury stock)
Net CFF = Proceeds from Debt + Proceeds from Stock Debt Repayments Dividends Stock Buybacks
Example
A company:
- Borrows $100,000
- Repays $30,000 of old debt
- Pays $20,000 in dividends
- Issues $50,000 in new stock
Net CFF = $100K + $50K $30K $20K = $100,000
The final statement combines all three sections to explain the change in cash.
Net Cash from Operating Activities
+ Net Cash from Investing Activities
+ Net Cash from Financing Activities
= Total Net Change in Cash
+ Beginning Cash Balance
= Ending Cash Balance
Full Cash Flow Statement
- CFO: +$200,000
- CFI: −$150,000
- CFF: +$100,000
- Total Change in Cash: $150,000
- Beginning Cash: $50,000
- Ending Cash: $200,000
WHY THE SCF MATTERS
Assess quality of earnings
Is net income backed by real cash?
Check liquidity
Can the company fund operations?
Understand strategy
Is the company investing heavily? Paying dividends?
Forecast future cash flows
Essential for valuation models like DCF
Exam Weight & Critical Areas
Cash Flow Statement analysis accounts for 7-10% of Level I FSA weight. Master these areas:
- Direct vs. Indirect Method - Converting between methods and understanding CFO adjustments
- Working Capital Adjustments - How changes in A/R, Inventory, A/P affect CFO
- Non-cash Items - Depreciation, gains/losses, adding back/subtracting from net income
- Classification of Cash Flows - CFO, CFI, CFF - what goes where
- Free Cash Flow - Calculating FCF to the firm and FCF to equity
ESSENTIAL FORMULAS
Cash Received from Customers (Direct Method):
Cash Received = Revenue - Increase in A/R
Cash Paid for Inventory (Direct Method):
Step 1: Purchases = COGS + Increase in Inventory
Step 2: Cash Paid = Purchases - Increase in A/P
CFO (Indirect Method):
CFO = Net Income
+ Depreciation & Amortization
+ Losses (- Gains) on Asset Sales
- Increase in A/R
- Increase in Inventory
+ Increase in A/P
Free Cash Flow to the Firm (FCFF):
FCFF = CFO + Interest(1 - Tax Rate) - FCInv
Free Cash Flow to Equity (FCFE):
FCFE = CFO - FCInv + Net Borrowing
Net Change in Cash:
ΔCash = CFO + CFI + CFF
COMMON PITFALLS
Working Capital Adjustment Direction: Increase in current assets (A/R, Inventory) = subtract from NI. Increase in current liabilities (A/P) = add to NI. Asset increase uses cash; liability increase sources cash.
Depreciation Treatment: Depreciation is non-cash, added back to NI in indirect method because it reduced NI but involved no cash. Cash was spent when the asset was purchased (shows in CFI).
Gains/Losses on Asset Sales: Gains are subtracted from NI (included in NI but not operating). Losses are added to NI. Full sale proceeds go in CFI, not CFO.
Interest and Dividends Classification: Under U.S. GAAP, interest paid = CFO; dividends paid = CFF. Under IFRS, company can choose to classify interest and dividends paid as either CFO or CFF.
Direct vs. Indirect Methods: Both methods produce the same CFO total. Only the presentation format differs - indirect starts with NI and adjusts; direct shows actual cash inflows and outflows.