accounting made sense

Table of Contents

Statement of Cash Flows – Simple Definition & Examples

Statement of Cash Flows – Simple Definition & Examples Featured Image

Table of Contents

Statement of Cash Flows in Simple Words

Statement of Cash Flows (SCF) shows where a business’ money came from and where it spent that money.

The Statement of Cash Flows shows how well a business handles its cash by providing a summary of 

  • Source of cash – Where the money came from (collecting from customers, earning the interest income from a savings account, winning a lottery ticket, etc.)
  • Usage of cash – Where the money was spent (buying inventories, buying new equipment, investing in the stock market, paying off a loan, etc.)

Unlike Income Statement, which shows how profitable a business is, Statement of Cash Flows shows its ability to manage cash. 

Profit vs. cash isn’t the same concept. For instance, a very profitable business has made $1M in profit. But one day, the owner decided to invest all of them in a volatile cryptocurrency. By looking at the Income Statement, investors can only see the $1M profit (as buying cryptocurrency/stocks does not generate profit or loss itself – that only happens when they are sold). However, if investors pay attention to their Statement of Cash Flows, they can identify questionable cash spending.

Purpose of Statement of Cash Flows

As one of the four financial statements, Statement of Cash Flows has the following primary purposes: 

  1. To highlight the cash inflow and outflow of a business. As Balance Sheet focuses on a company’s overall assets and liabilities, and Income Statement shows the profitability of a business, Statement of Cash Flows fills up the gap by summarizing cash activities. One can run a profitable business, but managing cash is a different skill. A businessman who made $1M last year can easily gamble his fortune away overnight.
  2. To predict whether a business will have cash trouble. For instance, a business only generated $100,000 cash from operating activities this year, but a $300,000 loan will be due next year. Based on the Statement of Cash Flows, it appears that simply generating cash from regular business operations may not be sufficient to repay the loan. As a result, the business may require a loan extension or need to identify alternative sources of cash.

Two formats of Statement of Cash Flows

In today’s business, there are two commonly used formats for the Statement of Cash Flows. Both formats feature the same three activity groups: Operating, Financing, and Investing (the classification of each group is discussed in the section below). The primary difference between the two formats is how a business presents its cash flow from day-to-day operating activities. 

Direct Method – easy to understand, suitable for mom-and-pop shops

  • In the operating activities section:
    • The first section shows exactly where cash comes from.
    • The section below shows where the cash was spent.
    • The difference between the two sections is the amount of cash left for this period.

Indirect Method – less straightforward, meant for companies with lots of transactions, more widely used among big, publicly traded companies.

  • In the operating activities section:
    • The first row is the net income of the period. (Ex: a year)
    • The rows below add back or subtract activities that would change net income but not cash. 
      • For example, tax payable. The tax expense has already been included in calculating the net income, but the cash still technically stays in the owner’s pocket until it’s due. Therefore, to calculate the actual cash number, the amount of tax payable is backed out from net income.
    • After backing out or adding back those activities, it will arrive at its final cash number left from the period. In other words, this method reconciles the net income and cash.

To summarize the difference in operating activities, for the Direct Method, a simple calculation is done by subtracting cash outflow from cash inflow. For the Indirect Method, a reconciliation from Net Income to Cash is performed.

Statement of Cash Flows also presents cash inflow/outflow from financing and investing activities, though the presentations of those two groups of activities are the same for both the Direct/Indirect methods 

Here is a quick cheat sheet of the difference between the Direct vs. Indirect Method of Statement of Cash Flows:

Statement of Cash Flows Simple Examples

Pho my Life Noodle Shop (PML) presented its Statement of Cash Flow for the year ended 12/31/2024:

Direct Method

There are three types of activities displayed in the Statement of Cash Flows:

  • Operating Activities – ordinary day-to-day business activities
    • Note A – The first section shows the cash receipts. PML Noodle Shop had a total cash collection of $200,000, comprising $150,000 in food and $50,000 in beverage sales.
    • Note B – This section displays where the cash was spent. PML Noodle Shop had a total cash expenditure of $120,000 that included spending on ingredients for $50,000, Salaries for $60,000, and tax for $10,000
    • Note C – The total net cash from operating activities is a simple math. We deduct total cash expenditure ($120,000) from the total cash receipts ($200,000), netting $80,000 
  • Investing Activities – Cash spent for investment purposes
    • Note D: PML Noodle Shop invested $20,000 in Bitcoin last year. Therefore, the cash expenditure of $20,000 is displayed in this section.
  • Financing Activities – Cash received from lending/financing
    • Note E: PML Noodle Shop borrowed $10,000 from a bank last year. The inflow of cash is therefore displayed here.

Note F: Combining the three types of activities concludes the total cash inflow for the business, which is $70,000. It’s calculated by adding cash provided from operating activities $80,000, cash provided from financing activities $10,000, and subtracting cash used in investing activities ($20,000)

Note G: Some business also shows the cash balance at the beginning of the year versus at the end of the year. Based on the calculation above, PML had a net cash inflow of $70,000 last year. At the beginning of the year, PML had $20,000 in its cash account. With the addition of $70,000, they had an ending balance of $90,000 in their cash account at the end of the year.

Indirect Method

Similar to the Direct Method, three types of activities (operating, investing, and financing) are displayed. The only difference between the direct and indirect methods is the presentation of operating activities. 

  • Operating Activities
    • Note A: The first line in the operating activities always starts with the net income from the period (in this case, the year ended 12/31/2024)
    • Note B: This group of activities impacts net income but not cash. We need to reconcile net income to cash by adding or subtracting items, depending on their nature. (More discussed in the section below)
      • Increase in Tax Payable. The net income already included tax expense, but since the tax is not due, the cash is still in the bank account. Therefore, we are adding the $2,000 back.
      • Depreciation. The net income included the depreciation of kitchen equipment of $3,000. Depreciation is not a cash activity. When a business incurs depreciation, cash still stays in the same place. Therefore, we are adding the $3,000 back.
      • Increase in Accounts Receivable (AR). Revenue is recognized when Accounts Receivable is booked, not when cash is received. If AR goes up, it indicates that the supplier owes us cash. Therefore, to calculate the actual cash amount, we have to reduce those additional AR from net income (in this case, $25,000), as AR means cash recorded in net income but not in our bank account.
    • Note C: Net cash provided from operating activities is calculated by summing up those adjustments from Net Income. Net income $100,000+ Increase in Tax Payable $2,000 + Depreciation $3,000 – Increase in AR $25,000 = $80,000
  • Investing Activities
    • Note D: Same as the Direct Method, net cash used in investing activities is $20,000 for the cash invested in Bitcoin
  • Financing Activities
    • Note E: Same as the Direct Method, net cash provided from financing activities is the $10,000 PML noodle shop borrowed from the bank

Note F: Combining the three types of activities, the net cash provided throughout the year is $70,000. Calculated by Operating Activities $80,000 – Investing Activities $20,000 + Financing Activities $10,000

Note G: Same as the Direct Method, a business can show its beginning and ending cash balances in a year. The difference between the two is precisely the cash inflow of the year ($70,000 = $90,000 ending balance – $20,000 beginning balance)

Classification of Operating, Investing, and Financing Activities

One of the tricky areas of Statement of Cash Flows is how activities are classified. Here is a quick cheat sheet:

Operating Activities

Cash Inflow: 

  • Anything from the customers
  • Interest and dividend from your investment (Note: this is NOT an investing activity – see below). 
  • Anything else that’s not mentioned in investing or financing activities. (insurance proceeds, lawsuit collection, etc.

Cash Outflow:

  • Anything to the suppliers
  • Anything to the employees, landlord, or whatever the costs to maintain regular business operation
  • Interest paid on loans (Note: again, NOT an investing activity -see section below)
  • Anything else that’s not mentioned in investing or financing activities (Taxes, fees, fines, etc.)

Investing Activities

Cash Inflow:

  • Sale of investment (Stocks, bonds, etc.)
  • Sale of long-term assets (Equipment, Property, Intangible, etc.)
  • Collection of the principal amount from a loan lent to others (Not interest – that’d be operating activities)

Cash Outflow:

  • Purchase of investment (Stocks, bonds, etc.)
  • Purchase of long-term assets (Equipment, Property, Intangible, etc.)
  • Lending out a loan to others

Financing Activities

Cash Inflow

  • Proceeds from a loan borrowing
  • Sale of company’s equity (stocks, etc.)

Cash outflow

  • Paying back the principal amount of the loan (not interest – that’d be operating)
  • Buying back the company’s equity (stocks)
  • Issuing dividends to stockholders

To conclude, the most tricky elements of the Statement of Cash Flows classification are 

  • Loans. When a company collects interest or pays interest, it is classified as an operating activity. However, when it comes to the principal amount, the classification would switch to financing or investing activities.
  • Assets. Purchase or sales of long-term assets are classified as investing (Thinking of buying a house – a big part of the motivation is investing even though you live in it every day). Purchase or sales of intangible assets (Trademark, Customer relations, etc.) is also an investing activity. Only current assets that are used in day-to-day activities are classified as operating, such as buying inventories. 

Reconciliation from Net Income to Cash on the Statement of Cash Flows

Accounts Receivable on Statement of Cash Flows

  • Net income or revenue is recognized when Accounts Receivable (AR) increases, even if cash is not yet collected from customers. In order to perform the reconciliation from net income to cash, we have to back out AR increased from net income.
    • I sold you a chocolate bar for $5. My Net Income is $5 
    • You don’t have cash on you but will pay me later. I will then recognize an Accounts Receivable of $5. My AR just went from $0 to $5 because of this. 
    • Now, on my Statement of Cash Flows, my net income is $5. But to calculate the actual cash I have in my pocket, which is $0 because you still owe me, I have to back out that $5 increase in AR from my net income: $5 Net Income – $5 Increase in AR = $0 Cash in my pocket.
  • When a customer repays the cash, the amount owed in Accounts Receivable (AR) decreases, and the balance in the Cash account increases. However, this repayment does not affect net income, which was impacted when AR increased. Therefore, to reconcile net income to cash, we need to add back any decreases in the AR balance.
    • After a year, you paid me back the $5 for the chocolate bar, and my AR went down from $5 to $0. 
    • On my Statement of Cash Flows, my Net Income for this year is $0, assuming I didn’t sell you another chocolate bar this year. 
    • However, I now have the $5 cash in my pocket. So the reconciliation from net income to cash would look like this: $0 Net Income + $5 Decrease in AR = $5 Cash in my pocket.
  • To conclude, when AR increases, actual cash will be less than net income. When AR decreases, actual cash will be more than net income. During the reconciliation from net income to cash, increased AR is backed out from net income, and decreased AR is added back to net income. 

Here is a quick summary:

Accounts Payable on Statement of Cash Flows

  • Expense is recognized, and Net Income is reduced when Accounts Payable (AP) increases, even if cash is still in the business’ bank account. In order to perform the reconciliation from net income to cash, we have to add back AP increased to net income.
    • I bought a Taylor Swift concert ticket from you for $5. I haven’t been able to resell it for a profit. My Net Income (or net loss in this case) is $-5 
    • I don’t have cash on me, but I will pay you later. I will then recognize an Accounts Payable of $5. My AP just went from $0 to $5 because of this. 
    • Now, on my Statement of Cash Flows, my net income (or net loss) is $-5. But to calculate the actual cash I have in my pocket, which is $0, I have to add back that $5 increase in AP from my net income: $-5 Net Income + $5 Increase in AP = $0 actual cash in my pocket. 
  • When the business finally repays the cash, the Accounts Receivable (AP) amount decreases, and the Cash account balance decreases. However, this repayment does not affect net income, which was impacted when AP increased. Therefore, to reconcile net income to cash, we need to back out any decreases in the AP balance.
    • After a year, I sold the concert ticket for $10 and paid you back the $5. I now have $5 cash left in my pocket, and my AP went down from $5 to $0
    • On my Statement of Cash Flows, my Net Income for this year is $10.
    • However, I only have $5 cash in my pocket because I paid you back the other $5. So the reconciliation from net income to cash would look like this: $10 Net Income – $5 Decrease in AP = $5 actual cash in my pocket.
  • To conclude, when AP increases, actual cash will be more than net income. When AP decreases, actual cash will be less than net income. During the reconciliation from net income to cash, increased AP is added back to net income, and decreased AP is backed out from net income. 

Here is a quick summary:

 

Unearned Revenue on Statement of Cash Flows

  • Unearned revenue increases when cash is collected before the service is performed, preventing recognition of net income. To reconcile net income to cash, we need to add the increase in unearned revenue back to net income. 
    • You just paid me $5 to clean your house next year. I now have $5 in my pocket. 
    • On my Statement of Cash Flows, my Net Income is still $0 because I can’t recognize revenue for service yet to be performed.
    • To reconcile net income to cash, I need to add back the unearned revenue: $0 Net Income + $5 Increase in Unearned Revenue = $5 Cash.
  • Unearned revenue decreases when the service is finally performed. At this time, revenue would be recognized without collecting cash (because it has already been collected in the past). To reconcile net income to cash, decreases in unearned revenue need to be backed out from net income.
    • I finished cleaning your house, for which you paid me $5 last year. I have a $0 cash balance this year because you already paid in the previous year.
    • On my Statement of Cash Flows, my Net Income is $5 because I finally performed the service. But my cash balance is $0 this year, as you already paid me last year.
    • To reconcile net income to cash, I need to back out the unearned revenue: $5 Net Income – $5 Decrease in Unearned Revenue = $0 Cash.

Here is a quick summary:

Prepaid Expenses on Statement of Cash Flows

  • Prepaid expenses increase when cash is paid before service is performed, delaying expense recognition. To reconcile net income to cash, we need to back out the increase in prepaid expenses from net income. 
    • I paid you $5 to clean my house next year. I now have $-5 in cash balance (assuming I can overdraft from my bank account)
    • On my Statement of Cash Flows, my Net Income is still $0 because I can’t recognize the cleaning expense since it is to be performed next year.
    • To reconcile net income to cash, I need to back out the prepaid expense: $0 Net Income – $5 Increase in Prepaid Expenses = $-5 cash.
  • Prepaid expenses decrease when the service is finally performed. At this time, an expense would be recognized without actually paying the cash (because it has already been paid in the past). To reconcile net income to cash, decreases in prepaid expenses need to be added back to net income.
    • You finished cleaning my house, for which I paid $5 last year. I have a $0 cash balance this year because I already paid in the previous year.
    • On my Statement of Cash Flows, my Net Income is $-5 because I incurred the house cleaning service expense. But my cash balance is $0 this year, as I already paid you last year.
    • To reconcile net income to cash, I need to add back the prepaid expenses: -$5 Net Income + $5 Decrease in Prepaid Expense = $0 Cash.

Here is a quick summary:

Quick Q&A

Q: What is a Statement of Cash Flows and its importance?

A: Statement of Cash flow represents how cash flows in and out of a business. It is an important tool to evaluate a business’s ability to generate cash, control its spending, and manage debt or stay solvent. 


 

Q: What is the difference between a Statement of Cash Flows and Income Statement/Profit & Loss (P&L)

A: Statement of Cash Flows shows the inflow and outflow of cash only, while Income Statement or P&L shows the overall profitability of a business. Making tons of cash doesn’t necessarily mean a company is profitable or vice versa. Differences between financial statements are discussed here in detail. 


 

Q: What is the difference between a Statement of Cash Flows and Balance Sheet

A: Statement of Cash Flows shows the activities of cash only. In contrast, Balance sheet shows a snippet of a business’s entire asset and liability at a point in time (ex. 12/31/2024). Differences between financial statements are discussed here in detail.


 

Q: What is the difference between Direct vs. indirect Method of Statement of Cash Flows?

A: The only difference is how operating activities are presented (with financing and investing activities presented identically). The Direct Method calculates net cash by subtracting cash outflow from cash inflow, while the Indirect Method reconciles net income to cash balance. See examples above. 


 

Q: How does unrealized loss or gain impact Statement of Cash Flows?

A: Unrealized loss or gain does not impact Statement of Cash Flows. It simply has no cash effect.


 

Q: On the Statement of Cash Flows, where should the gain on sale of assets be categorized?

A: Under the Indirect Method, the proceeds from sales of assets such as equipment are classified as Cash Inflow from Investing Activities, while the portion of gain from such sale is reported as Cash Inflow from Operating Activities, which needs to be backed out when the reconciliation from Net Income to Cash is performed.


 

Q: On the Statement of Cash Flows, how should the disposal of fixed assets be categorized?

A: Under the Indirect Method, the proceeds from the disposal of fixed assets are classified as Cash Inflow from Investing Activities. However, any gains or losses from the sale are reported as Cash Inflow from Operating Activities, and they must be removed during reconciliation from Net Income to Cash. 


 

Q: What’s the most important category on the Statement of Cash Flows?

A: Many investors and analysts pay more attention to operating activities as they reveal a company’s ability to maintain a healthy cash flow from its day-to-day, ordinary business activities. 


 

Q: What’s the abbreviation of Statement of Cash Flows?

A: SCF – Statement of Cash Flows


 

Q: What’s the impact of revaluation surplus on Statement of Cash Flows?

A: Revaluation Surplus has no cash impact and will not affect Statement of Cash Flows. 


 

Q: Is Statement of Cash Flows optional?

A: No, it isn’t optional. Statement of Cash Flows is required under both US GAAP and IFRS. However, small, private businesses with no compliance requirement to prepare financial statements obviously do not need a Statement of Cash Flows. 

Leave a Reply

Your email address will not be published. Required fields are marked *

Advertisement