Cash flow: where the money actually goes

“Profit is an opinion, cash is a fact.” Nobody is sure who said it first, and it is a little unfair to accountants, who work hard to make profit a careful, rule-bound opinion. But it captures something important. A company can report healthy profits year after year and still run out of money, and a company that reports losses can be generating plenty of cash. The cash flow statement is the one financial statement that cannot be argued with in the same way, because it only records money that actually moved, and that is why many experienced investors read it first.

The gap between profit and cash comes from the way accounting works. Under the accrual principle, which nearly all companies follow, revenue is recorded when it is earned and costs when they are incurred, not when money changes hands. That is a sensible rule. It matches the costs of a period with the sales they helped produce, and it gives a truer picture of how a business is performing than a simple list of payments would. But it means that the income statement and the bank account can drift far apart.

Three things open the gap most often. The first is customers who have not paid yet. A sale on sixty-day terms counts as revenue on the day of the sale, but the cash arrives two months later, if it arrives at all. Until then it sits on the balance sheet as a receivable. The second is inventory. Money spent on materials or stock that has not yet been sold has left the bank, but it is not yet a cost on the income statement; it waits on the balance sheet until the goods are sold. The third is depreciation. A machine bought for 100,000 is paid for up front, but its cost is spread across its useful life, perhaps 10,000 a year for ten years. In the first year, cash falls by 100,000 while profit falls by only 10,000. In later years, profit is reduced by a cost that involves no payment at all.

The cash flow statement sorts every movement of money in a period into three groups. Operating activities are the cash from running the business: what customers paid, minus what was paid to suppliers, staff and the tax authorities. Most companies present this section by starting from net income and adjusting it for everything that was not cash, adding back depreciation, subtracting increases in receivables and inventory, and so on, which makes the gap between profit and cash visible line by line. Investing activities are the cash spent on, or received from, long-term assets: equipment, buildings, software, acquisitions of other companies, or the sale of any of these. Financing activities are the cash that comes from or goes to lenders and owners: new loans and repayments, new shares issued or bought back, and dividends paid.

The three sections add up to the change in the cash balance between the start and end of the period, which you can check against two balance sheets. Nothing is hidden. Every unit of currency that came in or went out has to be explained somewhere, which is what makes the statement so hard to dress up.

The number I care about most is free cash flow, which is usually calculated as operating cash flow minus capital expenditure, the money spent on equipment, buildings and other long-term assets needed to keep the business running and growing. It is the cash the business generates after keeping itself in working order. That is the money that can pay down debt, fund expansion, be paid out to owners or be kept as a cushion. A business with strong and steady free cash flow can choose what to do. A business without it depends on lenders and investors to keep going.

A small example shows how a profitable company can run out of cash. Imagine a furniture maker that is growing fast. A large retail chain signs up as a customer, sales double, and the income statement shows a healthy profit. But the retailer pays its invoices after ninety days. The factory has to buy wood months in advance to meet the larger orders. New machines are needed to handle the extra volume, and they have to be paid for now. Cash flows out long before it flows back in. The company is profitable on paper and short of money in the bank, and if its bank will not extend its credit, it can fail in the middle of its best year. This is one of the most common ways growing businesses get into trouble, and it is completely invisible if you only read the income statement.

There are a few patterns worth looking for when you read a cash flow statement. Over several years, operating cash flow should usually be at least as large as net income. If it is consistently lower, profits are not turning into cash, and it is worth finding out why: perhaps customers are paying more slowly, or inventory is piling up, or revenue is being recognised more aggressively than it should be. Receivables and inventory growing faster than sales are a sign that cash is getting trapped. And a company whose financing activities pay for its operations year after year, through new borrowing or new shares, does not fund itself. That can be fine for a young business investing heavily for growth, but it cannot go on for ever.

None of the three statements tells the whole story on its own. The balance sheet shows where a company stands on one day. The income statement shows how it performed over a period, by the rules of accrual accounting. The cash flow statement shows where the money actually went. Read together, they let you check each against the others, and the places where they disagree are usually where the most interesting questions are.