A company can report a profit and still run out of money. It happens often enough that professional investors check the cash flow statement almost as a reflex. This is Part 2 of our Read the Numbers series, and it follows the same hypothetical distributor through the same year as the income statement.
The SEC's Beginners' Guide to Financial Statements puts the distinction plainly: an income statement can tell you whether a company made a profit, while a cash flow statement can tell you whether the company generated cash. The guide also notes that it shows changes over time rather than absolute dollar amounts, which is why it's paired with a balance sheet that shows where cash stands on a given date.
The three sections
- Operating activities. Cash generated by the actual business: selling products, paying suppliers and employees. This section starts with net income and adjusts it into cash.
- Investing activities. Purchases or sales of long-term assets, such as property and equipment. A growing company usually shows cash going out here.
- Financing activities. Cash raised or returned through borrowing, repaying debt, issuing stock, or paying dividends and owner distributions.
Turning profit into cash
The operating section is where the action is. It begins with the $96,000 of net income from the income statement and then makes adjustments for items that moved profit but not cash, or cash but not profit.
| Line | Amount |
|---|---|
| Net income | $96,000 |
| Add back: depreciation (a non-cash expense) | $40,000 |
| Increase in accounts receivable | ($10,000) |
| Increase in inventory | ($20,000) |
| Increase in accounts payable | $5,000 |
| Cash from operating activities | $111,000 |
| Purchase of equipment | ($60,000) |
| Cash from investing activities | ($60,000) |
| Repayment of debt | ($25,000) |
| Owner distributions | ($20,000) |
| Cash from financing activities | ($45,000) |
| Net change in cash | $6,000 |
| Cash at start of year | $34,000 |
| Cash at end of year | $40,000 |
Each adjustment has a plain-language reason:
- Depreciation, +$40,000. It reduced profit but no cash left the building that year, so it's added back. The cash left earlier, when the equipment was bought.
- Accounts receivable, −$10,000. Customers owe the company $10,000 more than a year ago. That revenue counted as profit, but the cash hasn't arrived.
- Inventory, −$20,000. The company spent $20,000 more stocking shelves than it expensed. The money is sitting in goods, not in the bank.
- Accounts payable, +$5,000. The company owes suppliers $5,000 more than before, which means it has kept $5,000 of cash it will pay later.
The ending cash of $40,000 matches the cash line on the balance sheet in our earlier example. That's not a coincidence; it's how the statements are tied together, which we trace in Part 3.
Free cash flow: what's left after reinvesting
Free cash flow is the cash a business has left to pay down debt, pay owners, or save, after keeping the operation running. A company whose operating cash flow consistently exceeds its net income, as here, is turning its reported profit into real money. That's the pattern patient investors tend to look for.
When a profitable company runs short of cash
Now imagine a fast-growing version of the company. It reports a healthy profit, but it's extending credit to new customers and buying inventory ahead of a big season:
| Line | Amount |
|---|---|
| Net income | $50,000 |
| Add back: depreciation | $10,000 |
| Increase in accounts receivable | ($80,000) |
| Increase in inventory | ($60,000) |
| Increase in accounts payable | $20,000 |
| Cash from operating activities | ($60,000) |
This company is profitable and still lost $60,000 in operating cash. Unless it borrows or raises money, it eventually can't pay its bills. This is the situation the cash flow statement exists to expose, and it's why "profitable" and "healthy" aren't synonyms.
Four patterns worth noticing
- Operating cash flow persistently below net income. Profit may be getting booked faster than it's collected.
- Financing covering a cash shortfall in operations. If the money to keep the lights on comes from borrowing or selling shares, the business isn't yet funding itself.
- Heavy investing outflows. Not bad in itself, since growth costs money. The question is whether the spending is producing returns.
- A loss with positive operating cash flow. It can happen when large non-cash charges like depreciation drive the loss. Look at why.
Common questions
What's the difference between net income and cash flow?
Net income is an accounting measure of profit, which counts revenue when it's earned and expenses when they're incurred. Cash flow tracks money actually moving in and out. The gap between them comes from timing differences, such as unpaid customer invoices, and non-cash expenses like depreciation.
Why is depreciation added back on the cash flow statement?
Depreciation reduces reported profit but doesn't involve a cash payment in the period. It's added back to net income to get closer to actual cash. The cash was spent earlier, when the asset was purchased, and shows up in investing activities then.
What is free cash flow?
Free cash flow is commonly calculated as cash from operating activities minus capital expenditures. It's the cash left over after maintaining and growing the asset base. Companies and data providers define it slightly differently, so check the formula behind any figure you see.
- U.S. Securities and Exchange Commission, Beginners' Guide to Financial Statements
- SEC, EDGAR company filing search