Statement of Cash Flows
Operating, Investing, and Financing Activities
Why This Matters
Here's the paradox that kills businesses:
A company reports $500,000 in net income. The owner is excited. Then three months later, the business runs out of cash and closes.
How is this possible? Because profit and cash are not the same thing.
Income Statement:
Accrual-based profit
What you “should have” made
Cash Flow Statement:
Actual cash movement
What you actually have
The statement of cash flows is the difference between theoretical profit and actual survival. Without it, you can't answer: “Do we have enough cash to pay our bills?”
What Is a Statement of Cash Flows?
The statement of cash flows is a financial report showing where cash came from and where it went during a specific period.
It's organized into three sections:
Operating
Core business cash
Investing
Long-term assets
Financing
Debt & equity
The Formula:
Cash from Operations
+ Cash from Investing
+ Cash from Financing
= Net Change in Cash
Beginning Cash + Change = Ending Cash
The Critical Insight: Why Profit ≠ Cash
Accrual Basis (Income Statement)
- • Revenue when earned (not received)
- • Expenses when incurred (not paid)
- • Shows profit (what you should have)
Cash Basis (Cash Flow Statement)
- • Only counts cash in
- • Only counts cash out
- • Shows cash (what you actually have)
The Reconciliation Gap:
Profit is $100,000 but operating cash is $93,000
Why the difference?
- • Depreciation isn't cash (but it reduced profit)
- • Receivables — revenue recorded but cash not received
- • Inventory — cash spent but not expensed yet
- • Payables — expenses recorded but cash not paid yet
The Three Sections
Operating Activities
Cash flows from running the core business. This is the MOST IMPORTANT section—it answers: 'Is the business actually generating cash?'
Key principle: Start with net income, then adjust for non-cash items to get actual cash
Why it matters: A profitable company with negative operating cash flow is in trouble
Investing Activities
Cash flows related to buying/selling long-term assets. Shows how much the company is investing for growth.
Key principle: Usually NEGATIVE (buying equipment, investments)
Why it matters: Shows investment in future growth or maintenance of existing assets
Financing Activities
Cash flows related to debt and equity. Shows how the company finances its operations.
Key principle: Can be positive (borrowing) or negative (repaying/dividends)
Why it matters: Reveals financing strategy and shareholder returns
Real-World Example: ABC Coffee Shop
Let's build a complete statement for ABC Coffee Shop for 2026:
ABC COFFEE SHOP
Statement of Cash Flows
For the Year Ended December 31, 2026
OPERATING ACTIVITIES
Adjustments to reconcile to cash:
INVESTING ACTIVITIES
FINANCING ACTIVITIES
Net Income: $26,250 (profitable) but Cash Change: +$250 (barely moved). Why? Operating generated $30,250, but investing used $15,000 and financing paid out $15,000.
Key Metrics from Cash Flows
Operating Cash Flow
Net Income + Adjustments (Depreciation, Working Capital Changes)
Example: $26,250 + $4,000 adjustments = $30,250
Meaning: The core business generated $30,250 in actual cash
Healthy: Should be positive and growing. Negative = burning cash
Free Cash Flow
Operating Cash Flow - Capital Expenditures
Example: $30,250 - $15,000 = $15,250
Meaning: Cash available after maintaining/expanding assets
Healthy: Available for dividends, debt repayment, or growth
OCF to Net Income Ratio
Operating Cash Flow ÷ Net Income
Example: $30,250 ÷ $26,250 = 1.15
Meaning: For every $1 of profit, you generated $1.15 in operating cash
Healthy: Ratio > 1.0 means you're converting profit to cash effectively
The Story the Cash Flow Tells
By looking at all three sections together, you can understand the company's strategy:
Growth Company
• Making money from operations
• Heavy investment in growth
• Borrowing to fund expansion
Investing aggressively for future growth, funded by operations and borrowing
Mature Company
• Steady cash generation
• Maintenance capex only
• Paying dividends & debt
Stable, shareholder-friendly. Using cash for returns and debt paydown
Distressed Company
• Struggling to generate cash
• Cutting back investment
• Borrowing to survive
Warning signs: weak operations, taking on debt just to stay afloat
Cash Flows: The Ultimate Reality Check
The beautiful truth about cash flows:
- •You can manipulate profit (timing, estimates, judgments)
- •You cannot manipulate cash
- •Cash is the ultimate scorekeeper
Income Statement says:
“We earned $100,000!”
Cash Flow says:
“Actually, we spent $20,000 net”
One of these is misleading. The cash flow is always telling the truth.
Key Takeaway
The statement of cash flows explains where cash actually moved, separated into operating (core business), investing (capital expenditures), and financing (debt and equity) activities. While the income statement shows profit, the cash flow statement shows sustainability. A profitable company with negative operating cash flow is in trouble. Understanding the three sections reveals the company's strategy: is it investing for growth, returning cash to shareholders, or struggling to survive?
Test Your Understanding
1. Which section of the cash flow statement is most critical for evaluating business health?
2. A company reports $100,000 net income but $150,000 in depreciation expense. Operating cash flow would be:
3. Operating Cash Flow is $50,000 and Capital Expenditures are $30,000. What is Free Cash Flow?
4. A company shows positive Net Income but negative Operating Cash Flow. This indicates:
5. True or False: A company with negative investing cash flow is in financial trouble.
Ready to Practice?
Reconcile profit to cash
You now understand why cash differs from profit and how to read cash flows. The Practice Lab is where you'll prepare cash flow statements and understand the three-part story.
Try the Practice Lab