Profit tells you whether a business earned more than it spent on an accrual basis. The cash flow statement tells you something more basic: how much cash actually came in and went out, and why. A company can report profits and still run out of cash; the cash flow statement is where that risk becomes visible.
Under IFRS the statement is governed by IAS 7 Statement of Cash Flows. It classifies every cash movement into three activities and reconciles opening cash to closing cash.
What you will learn
- Classify cash flows into operating, investing and financing activities
- Prepare operating cash flow using the indirect method
- Explain why profit and operating cash flow differ
- Calculate and interpret free cash flow
The three activities
| Activity | What it covers | Typical inflows | Typical outflows |
|---|---|---|---|
| Operating | The main revenue-producing activities | Cash from customers | Payments to suppliers, staff, tax |
| Investing | Acquiring and disposing of long-term assets and investments | Sale of equipment or investments | Purchase of property, plant and equipment |
| Financing | Changes in the size and composition of equity and borrowings | New loans, share issues | Loan repayments, dividends, lease principal |
IAS 7 allows some choices for interest and dividends: interest paid may be shown in operating or financing activities, and dividends paid in financing or operating, provided the choice is applied consistently. (IFRS 18, effective from 2027, narrows these choices for most companies.) When comparing companies, check where these items are classified.
Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash with insignificant risk of changes in value — typically those with an original maturity of three months or less.
Direct and indirect methods
The direct method lists the main classes of gross cash receipts and payments: cash received from customers, cash paid to suppliers and employees, and so on. IAS 7 encourages it because it is easier to understand.
The indirect method starts with profit and adjusts for non-cash items and changes in working capital. Most companies use it because it is easier to produce from the accounting records, and it explains clearly why profit and cash differ.
Operating cash flow — indirect method
Operating cash flow = Profit before tax + Non-cash expenses (depreciation, amortisation, impairment) − Non-cash gains ± Changes in working capital − Tax paid
An increase in a current asset (receivables, inventory) reduces cash; an increase in a current liability (payables) increases cash.
Worked example: indirect method
A manufacturer reports the following for the year (illustrative figures):
- Profit before tax 400,000, including depreciation of 120,000 and a gain of 20,000 on selling a machine.
- Receivables rose by 70,000; inventory rose by 50,000; trade payables rose by 30,000.
- Interest paid 40,000 (already deducted in profit; classified here in financing) and tax paid 90,000.
- The machine sold for 60,000; new equipment cost 300,000.
- New bank loan 150,000; dividends paid 100,000.
Operating activities:
- Start with profit before tax: 400,000.
- Add back depreciation: +120,000. Remove the gain on sale (it is investing cash, not operating): −20,000.
- Add back interest expense, because it is shown under financing: +40,000. Subtotal 540,000.
- Working capital: receivables −70,000; inventory −50,000; payables +30,000. Subtotal 450,000.
- Tax paid: −90,000. Net cash from operating activities: 360,000.
Investing: proceeds 60,000 − purchases 300,000 = −240,000. Financing: loan 150,000 − interest 40,000 − dividends 100,000 = +10,000.
Net increase in cash = 360,000 − 240,000 + 10,000 = 130,000.
Why profit and operating cash differ
- Non-cash expenses such as depreciation reduce profit but not cash.
- Working capital absorbs cash when a business grows: more stock and more credit to customers.
- Timing of tax and interest payments differs from when they are expensed.
- Gains and losses on disposals relate to investing activities, not operations.
A business whose operating cash flow is persistently far below profit deserves a closer look. It may be growing fast, or it may be recognising revenue that never turns into cash. This is a central idea in earnings quality analysis.
Free cash flow
Free cash flow (FCF) is not defined by IFRS, so companies and analysts calculate it in different ways. A common and simple version is:
Free cash flow (simple version)
Free cash flow = Net cash from operating activities − Capital expenditure
In the example: 360,000 − 300,000 = 60,000. This is the cash left after maintaining and expanding the asset base, available for debt repayment, dividends or saving.
Valuation work uses more precise definitions, such as free cash flow to the firm, explained in discounted cash flow valuation.
Reading a cash flow statement
A useful first pass:
- Is operating cash flow positive and stable? A mature business should generate cash from its operations.
- How does it compare with profit? Over several years, operating cash flow should broadly track or exceed profit.
- What is being invested? Capital expenditure well above depreciation suggests expansion; far below may mean under-investment.
- How is the gap financed? Persistent reliance on new borrowing to pay dividends is a warning sign.
- Read the notes for non-cash transactions, such as assets acquired through leases, which do not appear in the statement itself.
Limitations
Cash flows can be timed: delaying supplier payments at year end flatters operating cash flow. One year can be distorted by a large purchase. Classification choices make comparisons harder. And cash flow says nothing about profitability on its own — it must be read with the income statement and balance sheet, as explained in the financial statements.
Common mistakes
- Treating an increase in receivables as a cash inflow; it is an outflow.
- Forgetting to remove gains on asset sales from operating cash flow.
- Double counting interest by deducting it in profit and again in financing.
- Comparing free cash flow figures calculated with different definitions.
Key terms
- Operating activities — the principal revenue-producing activities of the entity.
- Investing activities — purchase and sale of long-term assets and investments.
- Financing activities — changes in equity and borrowings, including dividends.
- Indirect method — reconciles profit to operating cash flow through non-cash items and working capital.
- Free cash flow — cash from operations less capital expenditure (one common definition).
Frequently asked questions
Can a profitable company have negative operating cash flow?
Yes. Fast growth can tie up cash in receivables and inventory, or revenue may be recognised before customers pay. Persistent negative operating cash flow is a warning sign even when profit is positive.
Is the direct or indirect method better?
The direct method is easier to understand; the indirect method shows why profit and cash differ. Both give the same net operating cash flow.
Why is depreciation added back?
Depreciation reduces profit but involves no cash payment in the period; the cash left when the asset was bought, and that is shown in investing activities.
Key takeaways
- The cash flow statement explains the change in cash through operating, investing and financing activities.
- The indirect method starts with profit and adjusts for non-cash items and working capital.
- Growth, timing and non-cash items explain why profit and operating cash differ.
- Free cash flow (operating cash less capital expenditure) shows cash available after investment.