The Statement of Cash Flows (SCF) is one of the most important financial statements, alongside the balance sheet and income statement. It shows how cash moves in and out of a company during a specific period.
While the income statement records revenues and expenses on an accrual basis, the SCF focuses on actual cash movements — offering a clear picture of liquidity, solvency, and financial flexibility.
Usefulness of the Statement of Cash Flows
The statement of cash flows helps investors, creditors, and management assess a company’s:
1. Ability to generate future cash flows
Cash flow trends reveal whether operations can sustain growth and dividends.
2. Ability to pay dividends and obligations
It highlights how well a firm meets debt repayments and shareholder returns.
3. Reasons for the difference between net income and cash flow
Depreciation, accruals, and noncash adjustments are clarified here.
4. Cash investing and financing activities
Shows how cash is used for asset purchases, investments, or paying dividends.
Thus, the SCF acts as a bridge between net income and changes in cash balances.
Format of the Statement of Cash Flows
Cash receipts and payments are classified into three main activities:
- Operating Activities
- Investing Activities
- Financing Activities
1. Operating Activities
Operating activities include the cash effects of transactions that create revenues and expenses — essentially, day-to-day business operations.
These activities involve income statement items such as sales, wages, and taxes.
Examples of Cash Inflows
- From sales of goods or services
- From interest and dividends received
Examples of Cash Outflows
- To suppliers for inventory
- To employees for wages
- To the government for taxes
- To lenders for interest
- To others for miscellaneous expenses
Operating activities determine a firm’s ability to sustain itself without external financing.
2. Investing Activities
Investing activities relate to the purchase or disposal of long-term assets and investments.
These activities show how management allocates resources for future growth.
Examples of Cash Inflows
- Sale of property, plant, and equipment (PPE)
- Sale of investments in debt or equity securities
- Collection of principal on loans made to others
Examples of Cash Outflows
- Purchase of property, plant, and equipment
- Purchase of debt or equity investments
- Making loans to other entities
Rule of thumb:
- (+ Investing) for cash inflows (sales)
- (– Investing) for cash outflows (purchases)
3. Financing Activities
Financing activities involve obtaining cash from creditors and stockholders, and repaying those amounts.
They affect long-term liabilities and equity accounts.
Examples of Cash Inflows
- From issuance of bonds, notes, or other debt
- From issuance of common stock
Examples of Cash Outflows
- To repay borrowed amounts
- To repurchase shares (treasury stock)
- To pay dividends to shareholders
Financing activities show how the company funds its operations and rewards investors.
Noncash Activities
Not all significant business transactions involve cash. These must still be disclosed because they affect financial position.
Examples include:
- Issuing stock to purchase assets
- Converting bonds into common stock
- Exchanging assets directly (without cash)
These transactions appear in a supplementary schedule rather than the main SCF.
Preparing the Statement of Cash Flows – Indirect Method
The indirect method is the most commonly used approach to prepare the SCF.
It starts with net income and adjusts for noncash transactions and changes in current assets and liabilities.
Step 1: Operating Activities
1. Start with Net IncomeThe figure is taken from the income statement.
Add back depreciation expense (+/Operating)
Because it reduces net income but doesn’t use cash.
Step 1A: Changes in Current Assets
| Change in Account | Adjustment | Example |
|---|---|---|
| Increase in a current asset | Deduct (–/Operating) | Increase in Accounts Receivable |
| Decrease in a current asset | Add (+/Operating) | Decrease in Inventory |
Examples:
- ↑ Accounts Receivable → (–/Operating)
- ↓ Prepaid Expenses → (+/Operating)
Step 1B: Changes in Current Liabilities
| Change in Account | Adjustment | Example |
|---|---|---|
| Increase in a current liability | Add (+/Operating) | Increase in Accounts Payable |
| Decrease in a current liability | Deduct (–/Operating) | Decrease in Taxes Payable |
Examples:
- ↑ Accounts Payable → (+/Operating)
- ↓ Income Taxes Payable → (–/Operating)
Step 2: Investing Activities
- Purchase of Land/Buildings/Equipment → (–/Investing)
- Sale of Fixed Assets → (+/Investing)
- Purchase of Investments → (–/Investing)
- Sale of Investments → (+/Investing)
Only deduct when assets are acquired for cash; only add when cash is received from asset sales.
Step 3: Financing Activities
- Increase in Bonds Payable → (+/Financing)
- Increase in Common Stock → (+/Financing)
- Payment of Dividends → (–/Financing)
- Repurchase of Treasury Stock → (–/Financing)
These activities reflect how the firm raises and uses capital.
Example Summary of Cash Flow Classification
| Transaction | Type | Cash Flow Effect |
|---|---|---|
| Depreciation expense | Operating | + |
| Increase in Accounts Receivable | Operating | – |
| Decrease in Inventory | Operating | + |
| Sale of Equipment | Investing | + |
| Purchase of Machinery | Investing | – |
| Issuance of Bonds | Financing | + |
| Dividends Paid | Financing | – |
Interpreting the Statement of Cash Flows
1. Operating Cash Flow (OCF) – Indicates if operations generate sufficient cash to sustain the business.A healthy company typically has:
- Positive OCF
- Negative ICF (due to reinvestment)
- Controlled FCF (used for repayments or dividends)
Example Illustration (Indirect Method)
Company X Statement of Cash Flows (Excerpt)
| Particulars | Cash Flow (+/–) | Type |
|---|---|---|
| Net Income | 120,000 | Starting Point |
| Add: Depreciation | +10,000 | Operating |
| Add: Decrease in Inventory | +5,000 | Operating |
| Less: Increase in Accounts Receivable | –15,000 | Operating |
| Cash from Operations | 120,000 | |
| Purchase of Equipment | –40,000 | Investing |
| Issue of Bonds | +30,000 | Financing |
| Dividends Paid | –10,000 | Financing |
| Net Increase in Cash | +100,000 |
This simplified layout helps visualize the company’s liquidity strength and investment patterns.
Summary
- The Statement of Cash Flows reports inflows and outflows of cash during a specific period.
- It explains differences between net income and cash balance changes.
- It classifies cash movements into operating, investing, and financing activities.
- The Indirect Method adjusts net income for noncash items and working capital changes.
- It provides crucial insights into a company’s ability to generate, invest, and manage cash efficiently.
FAQs About the Statement of Cash Flows
1. What is the main purpose of the Statement of Cash Flows?
To show how cash is generated and used during a specific period through operating, investing, and financing activities.
2. What is the difference between the direct and indirect methods?
The direct method lists actual cash receipts and payments; the indirect method adjusts net income for noncash transactions and working capital changes.
3. Why is depreciation added back in the indirect method?
Because it’s a noncash expense that reduces net income but doesn’t affect actual cash flow.
4. What are examples of investing activities?
Buying or selling long-term assets, investments, or loans to other entities.
5. What are financing activities?
Issuing stock, repaying debt, and paying dividends.
6. Why are noncash activities disclosed separately?
They affect the company’s financial structure even though no cash changes hands.
7. What indicates a healthy cash flow statement?
Positive operating cash flow, moderate investing outflows, and manageable financing outflows.
