A cash flow statement tracks every dollar that moved in and out of a business during a specific period, organized into three sections: operating activities, investing activities, and financing activities. Most businesses prepare this statement using the indirect method, which starts with net income from the income statement and adjusts it to reflect actual cash movement. To build one, you need your income statement for the period and balance sheets from the beginning and end of that same period.
What You Need Before You Start
The cash flow statement is derived from two other financial statements, so gather these first:
- Income statement for the period: You need net income as your starting point, plus specific line items like depreciation expense.
- Comparative balance sheets: You need the balance sheet from the start of the period and the end of the period. The changes between these two snapshots reveal where cash went.
You also need the ending cash balance from the prior period, which becomes your beginning cash balance. The entire point of the statement is to show how you got from that beginning balance to the ending balance on your current balance sheet.
Choose Your Method: Direct or Indirect
There are two ways to present the operating activities section. The indirect method starts with net income and adjusts for non-cash items. The direct method lists actual cash receipts and payments, recording money collected from customers, paid to suppliers, paid to employees, and so on. Both methods produce the same final number for cash from operations.
The vast majority of businesses use the indirect method. It is simpler to prepare because it pulls directly from accrual-based financial statements you already have, rather than requiring you to track every individual cash transaction. The rest of this guide follows the indirect method.
Section 1: Cash From Operating Activities
This section answers a straightforward question: how much cash did day-to-day business operations generate or consume? Here is how to calculate it step by step.
Start With Net Income
Pull net income (or net loss) from your income statement. This is your baseline, but it includes non-cash charges and timing differences that need to be reversed or adjusted.
Add Back Non-Cash Expenses
Depreciation is the most common adjustment. Your income statement subtracted it as an expense, but no cash actually left the business when depreciation was recorded. Add it back. Do the same for amortization of intangible assets and any other non-cash charges that reduced net income.
Adjust for Changes in Working Capital
Compare your beginning and ending balance sheets and calculate the change in each of these current asset and liability accounts:
- Accounts receivable: If receivables increased, customers owe you more money you haven’t collected yet. Subtract the increase. If receivables decreased, you collected more cash than you billed, so add the decrease.
- Inventory: An increase means you spent cash buying or producing goods still on hand. Subtract it. A decrease means you sold through existing stock without spending as much to replace it. Add it.
- Prepaid expenses: An increase means you paid cash in advance for something. Subtract it.
- Accounts payable: An increase means you received goods or services but haven’t paid for them yet, keeping cash in your pocket. Add it. A decrease means you paid down what you owed. Subtract it.
- Accrued expenses: An increase means you recorded an expense but haven’t paid it in cash. Add it. A decrease means you paid off a prior accrual. Subtract it.
The logic follows a simple rule: increases in current assets use cash (subtract them), while increases in current liabilities provide cash (add them). Decreases work in reverse. Once you total net income, non-cash add-backs, and all working capital adjustments, you have your net cash from operating activities.
Section 2: Cash From Investing Activities
This section captures cash spent on or received from long-term assets. Common items include:
- Purchases of property, equipment, or other fixed assets: Cash outflows, shown as negative numbers.
- Proceeds from selling equipment or property: Cash inflows.
- Purchases or sales of investments: Buying stocks, bonds, or stakes in other companies.
- Loans made to other parties: Cash outflows when the loan is issued, inflows when it’s repaid.
Review the changes in long-term asset accounts on your balance sheet and identify any purchases or disposals during the period. The total of these items gives you net cash from investing activities. For most growing businesses, this number is negative because they are spending on equipment, technology, or expansion.
Section 3: Cash From Financing Activities
Financing activities involve transactions between the business and its owners or creditors. This section includes:
- Proceeds from issuing debt: Taking out a loan or issuing bonds brings cash in.
- Repayment of loans: Paying down principal is a cash outflow. (Note: interest payments can appear here or in operating activities depending on your accounting policy, but you should be consistent and disclose your choice.)
- Issuing stock or equity: Selling shares brings cash in.
- Dividends paid: Distributing profits to shareholders is a cash outflow.
- Buying back shares: Repurchasing your own stock is a cash outflow.
Review changes in long-term debt, notes payable, and equity accounts on your balance sheet to identify these transactions. Total them to get net cash from financing activities.
Tie It All Together
Once you have all three sections completed, the final calculation is simple:
Beginning cash balance + net cash from operating activities + net cash from investing activities + net cash from financing activities = ending cash balance.
Your ending cash balance should match the cash and cash equivalents line on your ending balance sheet. If it doesn’t, something was misclassified or omitted, and you need to trace back through your adjustments. Cash equivalents include short-term, highly liquid investments with a maturity of three months or less from the date they were acquired (not three months remaining at the reporting date).
Classifying Transactions Correctly
The most frequent errors in cash flow statements come from putting transactions in the wrong section. A few areas that trip people up:
Interest received can be classified as either an operating or investing activity, and interest paid can go in operating or financing. Pick a policy and apply it consistently. Whichever you choose, show interest amounts as separate line items rather than burying them inside a larger number.
Non-cash transactions should not appear on the cash flow statement at all. If you acquired equipment through a lease or bought a company by issuing stock, no cash changed hands. These transactions get disclosed in a separate note to the financial statements instead.
When classifying a payment, ask whether it relates to day-to-day revenue and expenses (operating), long-term asset purchases or sales (investing), or raising or repaying capital (financing). If a transaction doesn’t fit neatly, look at how it was recorded on the income statement and balance sheet for guidance.
A Simple Example
Suppose your business reported net income of $50,000. During the period, you recorded $8,000 in depreciation. Accounts receivable increased by $5,000, inventory decreased by $3,000, and accounts payable increased by $2,000. Your operating cash flow would be: $50,000 + $8,000 (depreciation) – $5,000 (higher receivables) + $3,000 (lower inventory) + $2,000 (higher payables) = $58,000.
Now say you bought $20,000 in equipment (investing outflow) and took out a $15,000 loan (financing inflow). Your net change in cash for the period is $58,000 – $20,000 + $15,000 = $53,000. Add that to your beginning cash balance, and you should land on the cash figure sitting on your ending balance sheet.
Working through a simple example like this before tackling a full statement helps you internalize the logic. Once you understand why each adjustment moves in the direction it does, preparing the statement for a real business with dozens of line items follows the same principles, just with more entries to track.