What Is the Statement of Cash Flows?
The statement of cash flows shows how cash moved into and out of a business during a period, broken into three categories: operating, investing, and financing activities. It exists because net income, the headline number on the income statement, does not equal cash generated, since it includes non-cash items like depreciation and timing differences from receivables and payables.
The Three Sections
- Operating activities:
cash generated or used by the core business, starting from net income and adjusting for non-cash items and changes in working capital. - Investing activities:
cash spent on or received from long-term assets, such as purchasing equipment or selling a property. - Financing activities:
cash from or paid to lenders and owners, such as borrowing, repaying debt, issuing shares, or paying dividends.
Summing the net cash flow from all three sections and adding the beginning cash balance gives the ending cash balance, which should tie exactly to the cash figure on the balance sheet.
Direct vs. Indirect Method
Both methods produce an identical result for operating cash flow. They differ only in how that section is presented.
- Indirect method:
starts from net income and adjusts for non-cash items like depreciation, then for changes in receivables, payables, and inventory. This is what almost every business actually uses, because the adjustments come directly from data already in the accounting system. - Direct method:
lists actual cash received from customers and actual cash paid to suppliers and employees, line by line. More intuitive to read, but it requires tracking gross cash receipts and payments separately from the accrual-based ledger, which most systems are not set up to do.
Accounting standards permit either, but strongly encourage disclosing a reconciliation to net income even under the direct method, which is one reason the indirect method dominates in practice: it produces that reconciliation automatically.
A Sample Statement of Cash Flows (Indirect Method)
EXAMPLE
Operating Activities
Net Income: $264,000
Add: Depreciation: $48,000
Less: Increase in Accounts Receivable: ($35,000)
Add: Increase in Accounts Payable: $22,000
Cash from Operating Activities: $299,000
Investing Activities
Purchase of Equipment: ($80,000)
Cash Used in Investing: ($80,000)
Financing Activities
Repayment of Debt: ($40,000)
Dividends Paid: ($25,000)
Cash Used in Financing: ($65,000)
Net Increase in Cash: $154,000
Notice that an increase in accounts receivable is subtracted, not added. Revenue was recognized on the income statement, but the cash has not arrived yet, so it has to be backed out to get to actual cash generated. An increase in accounts payable works the other way: an expense was recognized, but the cash has not left yet, so it is added back.
Why AP Timing Shows Up Directly in This Statement
Of the three sections, operating activities is the one most sensitive to how quickly a business processes its own invoices. Every dollar of accounts payable sitting unposted at period end is a dollar that has not yet reduced reported operating cash flow, because the adjustment in the indirect method only reflects payables that are actually recorded.
This means an AP backlog does not just distort the balance sheet, described above, it also distorts the cash flow statement: the payables increase looks smaller than it actually is, which understates the cash benefit the business is genuinely getting from stretching payment timing, whether that stretching is deliberate or just a processing delay.
Frequently Asked Questions About Statement of Cash Flows
1. What is the statement of cash flows?
The statement of cash flows shows how cash moved into and out of a business during a period, split into operating, investing, and financing activities. It exists because net income includes non-cash items and timing differences that do not represent actual cash movement.
2. What is the difference between the direct and indirect method?
Both produce the same operating cash flow figure. The indirect method starts from net income and adjusts for non-cash items and working capital changes, which is what most businesses use. The direct method lists actual cash received and paid, line by line, which requires additional tracking most systems are not set up for.
3. What are the three sections of a statement of cash flows?
Operating activities, covering cash from core business operations; investing activities, covering cash spent on or received from long-term assets; and financing activities, covering cash from or paid to lenders and owners.
4. What is an example of a statement of cash flows?
Starting from net income of $264,000, adding back $48,000 depreciation, subtracting a $35,000 receivables increase, and adding a $22,000 payables increase gives $299,000 in operating cash flow. Investing and financing activities are then added to reach the net change in cash.
5. Why is an increase in accounts payable added back on the cash flow statement?
Because an expense was recognized on the income statement but the cash has not left the business yet. Adding back the payables increase corrects net income to reflect that the cash is still on hand, even though the expense already reduced reported profit.
6. What is the purpose of the statement of cash flows?
It shows whether a business is actually generating cash from its operations, separate from accounting profit, which can include non-cash items. A business can be profitable on the income statement while generating little or negative operating cash flow, which this statement reveals and the income statement alone cannot.
