Difficulty: Intermediate | Prerequisites: Introductory financial accounting, familiarity with the balance sheet and income statement.
The statement of cash flows (SCF) bridges the gap between accrual-based net income and what a company actually collected and spent in cash during a period. It sits alongside the income statement and balance sheet as one of the three mandatory financial statements under both US GAAP and IFRS. If you can read a balance sheet and an income statement but have not yet studied cash flows, start here. Everything in this chapter builds on the idea that profit on paper and cash in the bank are two different things.
The SCF reports cash inflows and outflows across three categories: operating, investing, and financing. Operating activities are the most scrutinised because they show whether the core business generates enough cash to sustain itself. Most companies use the indirect method (starting from net income and adjusting), even though standard-setters prefer the direct method.
Statement of Cash Flows (SCF)
A financial statement summarising all cash inflows and outflows over a reporting period, organised by operating, investing, and financing activities. In simple terms, this is the report that shows where cash came from and where it went.
Operating activities
Cash transactions tied to the company's core revenue-generating operations, such as receipts from customers and payments to suppliers and employees. Think of it as the cash version of the income statement.
Investing activities
Cash flows from buying or selling long-term assets and investments, such as property, equipment, or securities. In simple terms, this covers spending on (or cashing out of) things the company plans to hold for more than a year.
Financing activities
Cash flows related to borrowing, repaying debt, issuing shares, or paying dividends. Think of it as everything involving the company's capital structure.
Direct method
A presentation approach that lists specific cash receipts (from customers) and cash payments (to suppliers, employees, etc.) on the operating section. In simple terms, it shows the actual cash movements line by line, much like a personal bank statement.
Indirect method
A presentation approach that starts with net income and adjusts for non-cash items and changes in working capital to arrive at cash from operations. Think of it as working backwards from profit to figure out how much cash the business collected.
Depreciation add-back
Depreciation is a non-cash expense. Under the indirect method it is added back to net income because it reduced profit without any cash leaving the company. In simple terms, the company never wrote a cheque for depreciation, so we reverse it when calculating cash flow.
Non-cash items
Transactions that affect net income but involve no actual exchange of cash during the period, such as depreciation, amortisation, and unrealised gains or losses.
IFRS reconciliation starting point
Under IFRS, the figure reconciled to operating cash flows must begin with net income (not operating income or another subtotal).
The SCF tracks every dollar of cash that entered or left the business during the period
It answers a question the income statement cannot: did the company collect more cash than it spent?
Stakeholders (investors, creditors, analysts) use it to assess liquidity, solvency, and financial flexibility
Operating activities
Cash effects of transactions that determine net income
Examples: cash received from customers, cash paid to suppliers, cash paid for wages, interest paid, taxes paid
Operating activities are the default classification. If a cash flow does not clearly belong to investing or financing, it goes here
Investing activities
Purchases and sales of long-term assets (property, plant, equipment)
Purchases and sales of investment securities (other than trading securities under US GAAP)
Lending money to others and collecting on those loans
Financing activities
Borrowing money (issuing bonds, taking out loans) and repaying principal
Issuing and repurchasing the company's own shares
Paying dividends to shareholders
Direct method
Lists each major class of cash receipt and payment on the operating section
Preferred by FASB and IASB because it mirrors the format of investing and financing sections, making the whole statement consistent
Rarely used in practice because companies find it harder to compile
Indirect method
Starts with net income
Adds back non-cash expenses (depreciation, amortisation)
Adjusts for gains and losses on asset sales (these belong in investing, not operating)
Adjusts for changes in current assets and current liabilities (working capital changes)
Used by the vast majority of companies
Depreciation is added back because it reduced net income without any cash outflow
Gains on sale of assets are subtracted (the full cash proceeds appear in investing, so the gain portion would double-count)
Losses on sale of assets are added back for the same reason, in reverse
Increases in current assets (e.g. accounts receivable) are subtracted, because revenue was recorded but cash was not yet received
Increases in current liabilities (e.g. accounts payable) are added, because an expense was recorded but cash was not yet paid
Under IFRS, the reconciliation to operating cash flows must begin with net income (not a subtotal like operating income)
Interest paid and dividends paid may be classified as operating or financing under IFRS; US GAAP requires interest paid in operating and dividends paid in financing
Interest and dividends received may be classified as operating or investing under IFRS
Analysts rely on operating cash flow to judge whether a company can fund its own growth, service its debt, and return cash to shareholders without needing external financing. A company that consistently reports net income but negative operating cash flow is a warning sign, because it means profits exist on paper but not in the bank.
"Depreciation is a source of cash." It is not. Depreciation is added back under the indirect method only because it was subtracted when calculating net income. No cash moves when depreciation is recorded.
Confusing gains/losses with cash flows. A gain on sale of equipment is not an operating cash inflow. The entire cash received from the sale goes in investing activities. The gain is removed from operating to avoid double-counting.
Assuming the direct and indirect methods give different totals. They do not. Both methods produce the same net cash from operating activities. They differ only in presentation.
Classifying interest paid as a financing activity under US GAAP. Under US GAAP, interest paid is classified as operating, not financing. (IFRS allows either.)
Expect questions asking you to classify a transaction into operating, investing, or financing. The default is operating.
Be ready to prepare the operating section using both the direct and the indirect method from the same set of data.
Know that depreciation is added back under the indirect method, and be able to explain why.
IFRS vs US GAAP classification differences for interest and dividends are a common exam topic.
True or false: The direct method and the indirect method produce different totals for cash from operating activities.
Under the indirect method, is depreciation added to or subtracted from net income?
Fill in the blank: Under US GAAP, interest paid is classified as a(n) ______ activity.
True or false: If a cash flow cannot be clearly identified as investing or financing, it is classified as operating.
Under IFRS, the reconciliation to operating cash flows must begin with ______.
Answers: 1. False. 2. Added. 3. Operating. 4. True. 5. Net income.
Q: A company sells equipment for $50,000, recording a $10,000 gain. How does this appear on the SCF under the indirect method?
A: The $10,000 gain is subtracted from net income in the operating section (to remove the gain that was already included in net income). The full $50,000 cash received is reported as a cash inflow in investing activities.
Q: Why do standard-setters prefer the direct method even though most companies use the indirect method?
A: The direct method lists each major class of cash receipt and payment, which mirrors the format of the investing and financing sections. This makes the entire statement internally consistent and easier for users to interpret.
Q: A company reports net income of $200,000. Depreciation expense is $30,000, accounts receivable increased by $15,000, and accounts payable increased by $8,000. What is cash from operating activities under the indirect method?
A: $200,000 + $30,000 (depreciation add-back) - $15,000 (increase in receivables) + $8,000 (increase in payables) = $223,000.
Q: Under IFRS, where can a company classify dividends paid?
A: Under IFRS, dividends paid may be classified as either operating or financing activities. Under US GAAP, they must be classified as financing.
This connects to leases (Ch. 12) because lease payments split between operating and financing activities depending on the lease type. It also connects to tax accounting (Ch. 11), since deferred tax changes are a non-cash adjustment under the indirect method. Stock-based compensation (Ch. 13) is another non-cash expense added back when reconciling net income to operating cash flow.
Statement of cash flows, SCF, cash flow statement, operating activities, investing activities, financing activities, direct method, indirect method, depreciation add-back, non-cash items, working capital changes, IFRS cash flow classification, US GAAP cash flow, cash from operations, free cash flow, net income to cash reconciliation, interest paid classification