The cash flow statement, and why profit is not cash
The three sections, the items that move profit but not cash, what the signs of each section tell you, and how much of its profit a company turns into cash.
Key takeaways
- Profit follows accounting rules about when revenue and costs count; cash is what actually moved.
- Common mistakes: Calling a rise in cash "good" before checking which section it came from: borrowing also raises cash.
- Operating cash flow: cash from running the business. Most companies show it the indirect way: start from net profit, add back costs that used no cash, and adjust for working capital.
- Investing cash flow: cash spent on, or received from, long-lasting assets: machines, buildings, software, whole companies bought or sold.
- Financing cash flow: cash from or to lenders and owners: new loans, repayments, new shares, dividends and share buybacks.
Key idea
Profit follows accounting rules about when revenue and costs count; cash is what actually moved. The cash flow statement sorts every movement of cash into three groups: running the business (operating), buying and selling long-lasting assets (investing), and dealing with lenders and owners (financing).
The three sections
- Operating cash flow: cash from running the business. Most companies show it the indirect way: start from net profit, add back costs that used no cash, and adjust for working capital.
- Investing cash flow: cash spent on, or received from, long-lasting assets: machines, buildings, software, whole companies bought or sold.
- Financing cash flow: cash from or to lenders and owners: new loans, repayments, new shares, dividends and share buybacks. Some companies also put interest paid or lease payments here; the notes say which.
Items that change profit but not cash
- Depreciation and amortization: the cost of equipment and intangible assets, such as software, spread over their life. Added back.
- Impairments and write-offs: an asset is suddenly worth less, so a cost is booked, but no cash leaves. Added back.
- Share-based pay: staff paid partly in shares. A cost in the P&L, but no cash. Added back.
- A gain on selling an asset: it lifts profit, but the full sale price already shows in investing cash flow, so the gain is taken out of operating cash flow to avoid counting it twice.
| Pattern | Operating | Investing | Financing | What it often means |
|---|---|---|---|---|
| Young, fast-growing company | Negative | Negative | Positive | It burns cash to grow and raises money from investors or lenders to pay for it |
| Healthy mature company | Positive | Negative | Negative | It earns cash, reinvests some, and pays lenders and owners |
| Cash machine with few needs | Strongly positive | Small negative | Strongly negative | Large dividends or buybacks, because there is little to reinvest in |
| Company under strain | Negative | Positive | Positive | It sells assets and borrows to cover losses from running the business |
So-what
Before reading any single number, look at the three signs. They tell you which story you are in.
Worked case
A profitable distributor that borrowed to grow its cash
The prompt
An electronics distributor in Saudi Arabia (fictional, SAR millions) made a net profit of 40. Depreciation was 10, and it wrote off an old IT system worth 5 (no cash moved). Receivables rose 35, inventory rose 20 and payables rose 15. It spent 18 on new warehouses, took a new bank loan of 25 and paid dividends of 12. It started the year with 30 of cash. Build the cash flow statement and say what it tells you.
The structure
- Change in cash = operating + investing + financing (this comes from the question: where did the cash come from and go)
- Operating: profit, plus non-cash costs, minus cash tied up in working capital
- Investing: the warehouses
- Financing: the new loan minus dividends
- Quality check: operating cash flow as a share of net profit
Working it through
1. Operating cash flow
Profit 40, plus depreciation 10 and the write-off 5, minus receivables 35 and inventory 20, plus payables 15.
Operating cash flow (SAR millions):40 + 10 + 5 - 35 - 20 + 15 = 152. Investing cash flow
The warehouses send 18 out. Free cash flow is operating cash flow minus this capex.
Free cash flow (SAR millions):15 - 18 = -33. Financing cash flow
The new loan brings 25 in; dividends send 12 out.
Financing cash flow (SAR millions):25 - 12 = 134. Closing cash
Opening 30, plus operating 15, minus investing 18, plus financing 13.
Closing cash (SAR millions):30 + 15 - 18 + 13 = 405. Cash conversion
How much of the profit arrived as operating cash.
Operating cash flow as a share of net profit (percent):15 ÷ 40 × 100 = 37.5
The recommendation
Cash rose by SAR 10 million, but the business did not earn that increase: free cash flow was minus 3 million, and the rise came from a 25 million bank loan. Only 37.5 percent of the profit arrived as cash, because receivables grew by 35 million, almost as much as the profit itself. This means the company is paying a dividend out of borrowed money. The risk is that some receivables are never collected, in which case today's profit is overstated. As a next step, check how old the receivables are and which customers owe the most.
Risks: Receivables that are never collected would turn into write-offs; The new loan adds interest and must be repaid.
A company reports net profit of USD 120 million and operating cash flow of USD 90 million. What is its cash conversion (operating cash flow divided by net profit), in percent?
A logistics company in the UAE reports net profit of AED 50 million. That profit includes a gain of AED 8 million from selling a warehouse for AED 20 million in cash. Depreciation was AED 12 million and working capital did not change. What is operating cash flow, in AED millions?
Calling a rise in cash "good" before checking which section it came from: borrowing also raises cash. Forgetting to remove gains on asset sales from operating cash flow. Judging one year alone: cash flows are lumpy, so look at three to five years. Comparing companies without checking where each puts interest and lease payments, since the rules allow different choices.
A company sells its head office for cash. Where does the cash appear?
Operating cash flow is negative, investing cash flow is positive and financing cash flow is positive. What is the most likely story?
Which item is added back to net profit to find operating cash flow?
Sources for this lesson (1)
- Recognized public explanations of case-interview concepts and terms
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