A company can report record net income and still run out of cash. The statement of cash flows reconciles accrual profit to actual cash movement, and it is the only one of the three primary statements that ties directly to the bank account.
The cash flow statement is built from the income statement and the change in balance sheet accounts. Net income comes directly from the income statement. Every working capital adjustment comes from the change in a current asset or current liability on the balance sheet. Investing activities reflect changes in long-term assets. Financing activities reflect changes in long-term debt and equity.
KEY: The cash flow statement is a derived statement. It contains no new information that is not already in the income statement or the balance sheet. It reorganizes that information around cash.
The integrity check: beginning cash + CFO + CFI + CFF = ending cash. Ending cash must match the cash line on the closing balance sheet. If it does not, the statement is wrong.
Common mistakes
- Reversing the sign on working capital changes. An increase in receivables reduces cash. Trap: adding $20,000 ΔAR to net income instead of subtracting it. Asset up = cash down.
- Classifying dividends paid as CFO under US GAAP. Dividends paid are always CFF under US GAAP. Interest paid is CFO. The exam exploits this inconsistency.
- Forgetting that depreciation never appears in the direct method. Direct method shows cash. Depreciation uses no cash. Trap: subtracting depreciation as a cash operating cost.
Bottom line
- CFO + CFI + CFF equals the change in cash. Beginning cash plus the three sections must tie to ending cash on the balance sheet.
- The statement contains no new data; it reorganizes the income statement and balance sheet around cash.
- Indirect CFO starts with net income, adds back non-cash items, and adjusts for working capital changes (an asset increase reduces cash).
- Direct CFO lists actual receipts and payments: cash from customers = Revenue − ΔAR + ΔDeferred Revenue.
Exam shortcut
For working capital signs: "Asset up, cash down. Liability up, cash up." Apply this to every balance sheet movement. For IFRS/GAAP interest and dividends: GAAP is rigid (interest in CFO, dividends paid in CFF), IFRS is flexible (anywhere, but consistent across periods). For converting indirect to direct: take each income statement line, adjust by the related balance sheet account change, and total to the same CFO.
The full lesson (about 2,028 words, 14 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- analyzing cash flows I
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