Cash Flow Statement: Accounting Study Notes
October 11, 2026
đ” Cash Flow Statement
Main Topics Covered
- What a cash flow statement is and who uses it
- Purpose: liquidity, solvency, earnings quality and comparability
- History and the main differences between US GAAP and IAS 7
- The three activity categories: operating, investing and financing
- Disclosure of non-cash activities
- Preparation methods: direct vs. indirect
- Rules for calculating operating and financing cash flows, with a worked example
đ Definition and Overview
A cash flow statement (also called the statement of cash flows) is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents. It breaks the analysis down into operating, investing and financing activities.
- It is concerned with the flow of cash in and out of the business.
- As an analytical tool, it helps determine the short-term viability of a company, particularly its ability to pay bills.
- International Accounting Standard 7 (IAS 7) is the international standard that deals with cash flow statements.
đ„ Who Is Interested in Cash Flow Statements
| Group | What they need to know |
|---|---|
| Accounting personnel | Whether the organization can cover payroll and other immediate expenses |
| Potential lenders or creditors | A clear picture of the company's ability to repay |
| Potential investors | Whether the company is financially sound |
| Potential employees or contractors | Whether the company can afford compensation |
| Company directors | They govern the company and must ensure it does not trade while insolvent |
| Shareholders | Interest in the company's financial position |
đŻ Purpose
The cash flow statement shows the sources of a company's cash flow and how it was used over a specific time period.
- It is an important indicator of financial health: a company can report a profit on its income statement yet have insufficient cash to operate.
- It reveals the quality of earnings (how much came from cash flow as opposed to accounting treatment).
- It shows the firm's capacity to pay interest and dividends.
How It Differs from the Balance Sheet and Income Statement
The cash flow statement excludes non-cash transactions required by accrual basis accounting, such as:
- Depreciation
- Deferred income taxes
- Write-offs on bad debts
- Sales on credit where receivables have not yet been collected
The Statement Is Intended To
- Provide information on a firm's liquidity, solvency and financial flexibility (the ability to change cash flows in future circumstances).
- Help predict future cash flows and borrowing needs.
- Improve the comparability of different firms' operating performance by eliminating the effects of different accounting methods.
The cash flow statement has been adopted as a standard financial statement because it eliminates allocations that might be derived from different accounting methods, such as various timeframes for depreciating fixed assets.
đ°ïž History and Variations
- Cash basis financial statements were very common before accrual basis financial statements. The old "flow of funds" statements were cash flow statements.
- 1863, Dowlais Iron Company: the company had recovered from a business slump but had no cash to invest in a new blast furnace, despite having made a profit.
- To explain why, the manager made a new statement called a comparison balance sheet, which showed the company was holding too much inventory.
- This was the genesis of the cash flow statement used today.
Timeline of Standards
| Year | Event |
|---|---|
| 1973 | In the US, the FASB defined rules making it mandatory under US GAAP to report sources and uses of funds, but the definition of "funds" was unclear (net working capital might be cash, or the difference between current assets and current liabilities) |
| Late 1970s to mid-1980s | The FASB discussed the usefulness of predicting future cash flows |
| 1987 | FASB Statement No. 95 (FAS 95) mandated that firms provide cash flow statements |
| 1992 | The IASB issued IAS 7, Cash Flow Statement |
| 1994 | IAS 7 became effective, mandating cash flow statements |
US GAAP vs. IAS 7
The rules are similar, but some differences are:
| Topic | IAS 7 | US GAAP (FAS 95) |
|---|---|---|
| Cash vs. cash equivalents | Requires the statement to include changes in both cash and cash equivalents | Permits using cash alone or cash and cash equivalents |
| Bank overdrafts | Permits bank borrowings (overdraft) in certain countries to be included in cash equivalents rather than financing activities | Not stated |
| Interest paid | May be included in operating or financing activities | Must be included in operating activities |
| Direct method | The IASC strongly recommends the direct method but allows either method | When the direct method is used, a supplemental schedule must also present a statement using the indirect method |
- The IASC considers the indirect method less clear to users of financial statements.
- Cash flow statements are most commonly prepared using the indirect method, which is not especially useful in projecting future cash flows.
đ Cash Flow Activities
The standard specifies the cash flows and adjustments to be included under each of the major activity categories.
đ Operating Activities
Operating activities include the production, sales and delivery of the company's product as well as collecting payment from customers. This could include purchasing raw materials, building inventory, advertising and shipping the product.
Operating cash flows include:
- Receipts for the sale of loans, debt or equity instruments in a trading portfolio
- Interest received on loans
- Payments to suppliers for goods and services
- Payments to employees or on behalf of employees
- Interest payments (alternatively, these can be reported under financing activities)
- Purchases of merchandise
Items added back to (or subtracted from) net income to arrive at cash flows from operations generally include:
| Item | Note |
|---|---|
| Depreciation | Loss of tangible asset value over time |
| Deferred tax | Added back as a non-cash item |
| Amortization | Loss of intangible asset value over time |
| Gains or losses on sale of a non-current asset | Associated cash flows do not belong in the operating section (unrealized gains/losses are also added back from the income statement) |
| Dividends received from general reserves | Adjusted out of net income |
đïž Investing Activities
Examples of investing activities:
- Purchase or sale of an asset
- Loans made to suppliers
- Payments related to mergers and acquisitions
đŠ Financing Activities
Financing activities include inflows and outflows of cash between investors and the company, such as:
- Dividends paid
- Sale or repurchase of the company's stock
- Net borrowings
- Repayment of debt principal, including capital leases
- Other activities that impact the company's long-term liabilities and equity
Summary Comparison
| Category | Core idea | Typical examples |
|---|---|---|
| Operating | Day-to-day production, sales, delivery and collection | Supplier and employee payments, interest received |
| Investing | Buying and selling assets, loans, acquisitions | Asset purchases or sales, M&A payments |
| Financing | Cash exchanged between investors and the company | Dividends paid, stock repurchase, debt principal repayment |
đ« Disclosure of Non-Cash Activities
- Under IAS 7, non-cash investing and financing activities are disclosed in footnotes to the financial statements.
- Under US GAAP, non-cash activities may be disclosed in a footnote or within the cash flow statement itself.
Non-cash financing activities may include:
- Leasing to purchase an asset
- Converting debt to equity
- Exchanging non-cash assets or liabilities for other non-cash assets or liabilities
- Issuing shares
- Payment of dividend taxes in exchange for assets
đ ïž Preparation Methods
- The direct method results in a more easily understood report.
- The indirect method is almost universally used, because FAS 95 requires a supplementary report similar to the indirect method if a company chooses the direct method.
Direct Method
The direct method reports major classes of gross cash receipts and payments.
- Under IAS 7, dividends received may be reported under operating activities or investing activities.
- Taxes paid are reported under the activity they are directly linked to: operating, investing or financing.
- Under GAAP, dividends received from a company's investing activities are reported as an operating activity, not an investing activity (this differs from IFRS).
Indirect Method
The indirect method uses net income as a starting point, makes adjustments for all non-cash items, then adjusts for all cash-based transactions. It converts accrual-basis net income (or loss) into cash flow through a series of additions and deductions.
- An increase in an asset account is subtracted from net income.
- An increase in a liability account is added back to net income.
𧟠Rules for Operating Activities (Indirect Method)
These rules can be used to calculate cash flows from operating activities when given only a two-year comparative balance sheet and the net income figure. Cash flows from operating activities are found by adjusting net income for the change between beginning and ending balances of current assets, current liabilities, and sometimes long-term assets.
When comparing the change in long-term assets over a year, the accountant must be certain the changes were caused entirely by devaluation rather than purchases or sales (i.e. they must be operating items that neither provide nor use cash), or else they are non-operating items.
| Change | Effect on net income |
|---|---|
| Decrease in non-cash current assets | Added |
| Increase in non-cash current assets | Subtracted |
| Increase in current liabilities | Added |
| Decrease in current liabilities | Subtracted |
| Expenses with no cash outflows | Added back (depreciation and/or amortization are the only operating items with no effect on cash flows in the period) |
| Revenues with no cash inflows | Subtracted |
| Non-operating losses | Added back |
| Non-operating gains | Subtracted |
The general relationship is:
Worked Example: Accounts Receivable
A company has net income of $100 this year, and its A/R increased by $25 since the beginning of the year. All other current assets, long-term assets and current liabilities did not change.
Logic: the company uses accrual accounting (not cash based), so any income generated that has not yet been paid for in cash should be subtracted from net income. The increase in A/R means $25 of sales occurred on credit and have not yet been paid in cash.
Worked Example: Change in a Fixed Asset
When the Buildings and Equipment account decreases, the change is added back to net income. Net income is calculated as:
Net income is therefore decreased by the building's depreciation that year. This depreciation is not associated with an exchange of cash, so it is added back to remove the non-cash activity.
đł Rules for Financing Activities
Finding cash flows from financing activities is described as much more intuitive and needing little explanation.
| Outflows | Inflows |
|---|---|
| Reductions of long-term notes payable (cash repayment of debt) | Issuance of new notes payable |
| All dividends paid by the entity to outside parties | Dividend payments received from outside parties |
| Purchase of notes, stocks or bonds | Receipt of payments on such financing vehicles |
In more advanced situations, such as subsidiaries, the accountant must:
- Exclude intra-company dividend payments
- Exclude intra-company bond interest
A traditional equation (NCI appears as in the source):