Beginner3 min readFundamental Analysis and Financial Statements · 6/15
How to Read the Cash Flow Statement
The income statement tells you what the company earned on paper. The cash flow statement tells you where actual cash came from and where it went, which is a very different question.
What you will learn
Know the three sections of the cash flow statement.
See why operating cash flow can differ from net profit.
Compute free cash flow with an example.
The lesson as a short video · 24 seconds · Watch on YouTubeIn this lesson
Accounting records revenue when a sale happens and an expense when it belongs to the period, even if no cash has moved yet. That makes net profit describe the year's activity, but it also makes it differ from the cash in the till. The cash flow statement fixes that and shows the actual movement of cash.
The three sections
Operating activitiesCash from the core business: collecting from customers, paying suppliers, wages and taxes.
Investing activitiesBuying or selling long-lived assets such as equipment and buildings, or stakes in other companies.
Financing activitiesNew loans or repayments, raising capital, and dividends to shareholders.
Operating+103
Profit 93 + depreciation 40 − working capital increase 30
Investing−70
Buying new equipment
Financing−30
Loan repayment 20 + dividends 10
Net change in cash+3
Cash goes from 77 at the start to 80 at the end
The invented company Al Wadi Foods, in EGP millions, with the operating section on the indirect method.
From net profit to operating cash flow
The operating section can be presented in two ways: the direct method, which shows the cash actually received and paid, and the indirect method. Under the indirect method, the operating section starts from net profit and adjusts it. Here: profit 93; add back depreciation of 40, a paper expense with no cash leaving this year. Subtract 30 because it is a net increase in operating working capital: higher receivables mean sales not yet collected, and higher inventory means cash tied up in goods not yet sold. Result: 93 + 40 − 30 = 103.
Free cash flow
ExampleFree cash flow = operating cash flow − spending on fixed assets. Here 103 − 70 = 33 million. It is the cash left after the company paid for the equipment it needs, and it funds debt repayment or dividends. This is a common analytical formula for free cash flow, not a standard accounting line item, and other analyses define it differently. The company paid out 30 million in financing, so cash rose by only 3.
Watch outA negative investing figure is not necessarily bad: the company may be building a new plant. A positive financing figure is not necessarily good: it may be a new loan. Read the reason in each section, not just the sign.
If net profit is high year after year while operating cash flow stays far below it, that raises an important question, covered in earnings quality.
Read a real cash flow statement
Open any company's statements from the disclosure archive and compare operating cash flow with net profit for the same year.