What you'll learn
A cash flow statement explains how a business moved from the cash it held at the start of the year to the cash it holds at the end. It answers a question neither of the other statements can: the income statement reports profit, which is calculated on the accruals basis and includes revenue not yet received and expenses not yet paid, while the statement of financial position reports a closing cash figure without saying how it got there.
That gap matters because profit and cash are different things. A business can report a healthy profit and be unable to pay its suppliers, because the profit is tied up in inventory and receivables. It can also report a loss and hold plenty of cash, because it sold a building. Businesses fail for want of cash, not for want of profit, which is why this statement exists.
The statement has three sections — operating, investing and financing activities — and the skill is knowing which cash movement belongs in which, and how to convert an accruals profit back into an operating cash figure.
Key terms and definitions
Operating activities — cash generated by the main trading of the business.
Investing activities — cash spent on or received from non-current assets and investments.
Financing activities — cash raised from or repaid to providers of long-term finance, plus drawings or dividends.
Indirect method — starts from profit and adjusts it back to operating cash. The method almost always required at CAPE.
Direct method — lists actual cash receipts from customers and payments to suppliers and employees. Simpler to read, rarer in practice because the data is harder to extract.
Non-cash expense — an expense reducing profit without any cash leaving, principally depreciation, amortisation and a loss on disposal.
Working capital movement — the change in inventory, receivables and payables between the two year ends.
Cash and cash equivalents — cash, bank balances and short-term deposits, less any overdraft.
Core concepts
Why profit is not cash
Four things drive the gap. Depreciation reduces profit but moves no cash. Credit sales increase profit before any cash arrives. Inventory purchases consume cash before any profit is recognised. Capital expenditure consumes cash and never appears in the income statement at all, except gradually as depreciation.
The indirect method reverses each of these in turn, which is why it looks like a list of corrections rather than a calculation. That is exactly what it is.
Adjusting for non-cash items
Start with profit before interest and tax. Add back every expense that reduced profit without moving cash — depreciation first, then any loss on disposal. Deduct any non-cash income, principally a profit on disposal.
A profit on disposal is deducted rather than added, which catches candidates out every year. The reasoning is that the whole of the sale proceeds appears lower down under investing activities, so leaving the profit in the operating section would count part of the same cash twice.
Working capital movements
An increase in inventory means cash was spent on stock that has not yet been sold, so it is deducted. An increase in receivables means sales were made without cash arriving, so it is deducted. An increase in payables means goods were obtained without paying yet, so it is added. Each decrease reverses its sign.
There is a single principle underneath: an increase in an asset consumes cash, an increase in a liability provides it. A candidate who remembers the principle can derive all six cases; a candidate who memorises six rules will reverse one under pressure.
The three sections
Operating covers trading. Interest paid and tax paid are usually shown here at CAPE, as the final deductions before net cash from operating activities.
Investing covers the purchase and sale of non-current assets. Note that it is the proceeds of a disposal that appear, not the profit or the carrying amount.
Financing covers long-term funding: loans raised and repaid, capital introduced, and drawings for a sole trader or partnership, or dividends paid for a company. Note that only the principal of a loan repayment appears here — the interest sits in the operating section.
Reading the pattern across the three sections
Once the statement is prepared, the combination of signs across the three sections tells a story that no single figure does, and examiners reward candidates who can read it.
Operating positive, investing negative, financing negative is the healthy mature pattern: trading generates cash, some is reinvested in assets, and the rest repays lenders or rewards the owner. That is the pattern in the worked example below.
Operating positive, investing heavily negative, financing positive is a business expanding: trading covers part of the investment and borrowing or new capital funds the rest. It is not a warning sign in itself, but it depends on the new assets eventually lifting operating cash.
Operating negative, financing positive is the pattern that should worry a lender. Trading is consuming cash and borrowing is filling the gap. A young business may survive that for a period; an established one doing it repeatedly is heading for trouble, however healthy its reported profit looks.
Operating negative, investing positive means the business is selling assets to fund day-to-day trading, which is the least sustainable position of all — the assets can only be sold once.
The point to carry into an evaluation question is that cash flow reveals the direction of a business more honestly than profit does, because the figures are far harder to influence through accounting policy. Depreciation method and inventory valuation change reported profit substantially; neither changes the cash in the bank by a cent.
The final check
The three sections sum to the net change in cash, which added to the opening balance must give the closing balance shown in the statement of financial position. If it does not, the statement is wrong and no amount of presentation will rescue it.
Perform this check before you write anything else down in the exam, because it tells you whether to hunt for the error while there is still time.
Worked examples
Example 1 — Operating activities, indirect method (8 marks)
Profit for the year $54,000, after loan interest of $5,000. Depreciation for the year was $18,000. Inventory rose from $48,000 to $52,000, receivables from $62,000 to $71,000, and payables from $38,000 to $44,000.
Profit before interest = $54,000 + $5,000 = $59,000. Add depreciation $18,000 → $77,000. Less increase in inventory ($52,000 − $48,000) = $4,000 → $73,000. Less increase in receivables ($71,000 − $62,000) = $9,000 → $64,000. Add increase in payables ($44,000 − $38,000) = $6,000 → $70,000. Less interest paid $5,000.
Net cash from operating activities = $65,000.
Note that the business generated $65,000 of cash from a $54,000 profit. Depreciation is the main reason, and the growth in receivables is what held it back.
Example 2 — Investing activities (4 marks)
During the year the business bought equipment for $30,000 and sold an old asset with a carrying amount of $28,000 for $34,000.
Purchase of equipment ($30,000). Proceeds from disposal $34,000.
Net cash from investing activities = $34,000 − $30,000 = $4,000.
The $6,000 profit on disposal does not appear here. It was removed from the operating section precisely so that the full $34,000 could be shown once, in this section.
Example 3 — Financing activities and the reconciliation (6 marks)
The business repaid $20,000 of loan principal and the owner withdrew $35,000. Cash at the start of the year was $4,000.
Financing: loan repaid ($20,000), drawings ($35,000) = ($55,000).
Net change in cash = $65,000 + $4,000 − $55,000. Working: $65,000 + $4,000 = $69,000; − $55,000 = $14,000 increase.
Cash at the end of the year = $4,000 + $14,000 = $18,000.
That figure must equal the bank balance in the statement of financial position. It does, so the statement reconciles.
Example 4 — Interpreting the statement (4 marks)
A weak answer says cash rose by $14,000. A strong one says: the business generated $65,000 from trading, comfortably covering the $30,000 invested in equipment, but $55,000 left in loan repayment and drawings — so almost the whole of the operating cash was consumed by financing decisions rather than reinvested. If the owner intends to expand, the level of drawings is the constraint, not trading performance.
That answer identifies where the cash went and what the owner could change, which is what the interpretation marks are for.
Common mistakes and how to avoid them
Adding a profit on disposal in the operating section. It is deducted; the full proceeds appear under investing.
Showing the carrying amount of a disposal under investing. Show the proceeds — the actual cash received.
Putting loan interest in the financing section. Interest is operating; only the principal repayment is financing.
Getting a working capital movement backwards. An increase in an asset consumes cash; an increase in a liability provides it.
Including depreciation as a cash outflow. It moves no cash at all and is added back.
Treating the purchase of a non-current asset as an expense. It is an investing outflow and never touches the income statement.
Failing to reconcile to the closing bank balance. Do this check first, not last.
How this links to your Internal Assessment
A cash flow statement turns an Internal Assessment from a set of statements into an analysis, because it is the statement a small-business owner most immediately understands. Prepare one for the business you have chosen, using the two years of statement of financial position figures you already have plus the depreciation charge.
The finding is usually the same and usually worth making: the owner's drawings, or the pace of credit given to customers, is consuming the cash that trading generates. Quantify it as Example 4 does, then recommend something specific — a fixed monthly drawing rather than ad hoc withdrawals, or tighter settlement terms.
If the business is too small to have meaningful non-current assets, the investing section may be nearly empty. Say so rather than padding it; an honest statement with two sections that matter beats an invented third.
Exam technique for cash flow statements
This question is generously marked and highly structured, which makes it one of the better questions to attempt when time is short. The marks follow the standard headings, so lay them out first — operating, investing, financing, net change, opening cash, closing cash — and fill in what you can.
Work the adjustments from the two statements of financial position side by side, computing each movement as closing less opening before you decide its sign. Label every figure; an unlabelled bracketed number cannot be awarded a mark because the examiner cannot tell what you intended.
Command words behave as they do elsewhere. Prepare means produce the statement with proper headings. Explain why depreciation is added back wants the non-cash reasoning, not the instruction. Comment on or assess the cash position wants a cause and a consequence — where the cash came from, where it went, and what the owner should do about it.
If your statement does not reconcile to the closing bank balance, state the difference and say where you would look. Presentation and section marks are still available.
Quick revision summary
- The statement explains the movement from opening to closing cash; profit and cash are not the same thing.
- Three sections: operating, investing, financing.
- Indirect method: start with profit before interest, add back depreciation and any loss on disposal, deduct any profit on disposal.
- A profit on disposal is deducted because the full proceeds appear under investing.
- Working capital: an increase in an asset consumes cash, an increase in a liability provides it.
- Interest paid sits in operating; only loan principal sits in financing.
- Investing shows the proceeds of a disposal, not the carrying amount or the profit.
- Financing covers loans, capital introduced, and drawings or dividends.
- The three sections plus opening cash must equal the closing bank balance — check this first.
- Interpretation means saying where the cash went and what the owner can change.