In plain English
This statement answers one question: where did the money actually go? It has three sections. Operating: cash from running the business. Investing: cash spent on or received from long-term assets. Financing: cash from lenders and owners, or paid back to them. Add the three and you get the change in the bank balance.
The advanced view
The indirect method starts from net income and strips out every non-cash and non-operating item: depreciation is added back because it never moved money, and changes in working capital are subtracted or added because they represent cash trapped in or released from the operating cycle. Reading it backwards is the standard test for whether earnings quality is deteriorating.
Depreciation is added back because it was subtracted on the income statement without any money leaving. The cash left years earlier when the asset was bought — and that purchase appears in investing, not operating. Adding it back is bookkeeping housekeeping, not a favour to the company.
Working capital changes hit cash directly. If receivables rise, you sold more than you collected: cash falls. If inventory rises, you bought more than you sold: cash falls. If payables rise, you are paying suppliers later: cash rises. Growth almost always eats cash for this reason — which is why fast-growing profitable companies still need financing.
Operating cash, the short way
Operating cash flow = Net income + Depreciation − Increase in working capital Free cash flow = Operating cash flow − Capital expenditure
Essential vocabulary
- Capex
- Capital expenditure — cash spent buying long-lived assets. Sits in investing, never in the income statement.
- Free cash flow
- Cash left after running the business and keeping the assets going. What owners and lenders can actually be paid from.
- Operating cash flow
- Cash generated by the core business, before buying assets or dealing with lenders.
- Non-cash expense
- A cost recorded on the income statement with no money moving — depreciation is the main one.
Common pitfalls
- ×Ignoring capex because it is 'below' operating cash flow. A capital-hungry business needs it just to stand still.
- ×Cheering strong operating cash that came entirely from stretching suppliers — that trick works once.
- ×Reading a single year. Cash flow is lumpy; look at three.
Why it works
Cash cannot be recognised early, deferred, or estimated. That is why the cash flow statement is the honesty check on the other two: judgement calls made in the income statement eventually show up here as a gap between profit and cash, and gaps that keep widening are the classic warning sign.
How it is used — profitable and broke
Step 1 of 6
- 1Net income 30, depreciation 20 → 50 before working capital.
Deeper
Deeper: free cash flow, and which one you mean
There are two free cash flows and confusing them is a classic interview trip. Free cash flow to the firm (FCFF) = EBIT × (1 − t) + D&A − capex − ΔNWC. It is pre-financing and is discounted at WACC to give enterprise value. Free cash flow to equity (FCFE) = FCFF − after-tax interest + net borrowing, discounted at the cost of equity to give equity value directly.
Growth consumes cash through working capital and capex. That is why a fast-growing profitable company borrows: the cash arrives after the costs. Conversely, a shrinking business releases working capital, so declining companies often look cash-generative right up to the point of collapse.
Must know cold
- ✓Operating cash flow = net income + non-cash charges − increase in working capital.
- ✓FCFF = EBIT(1 − t) + D&A − capex − ΔNWC; discount at WACC.
- ✓FCFE = FCFF − interest(1 − t) + net new debt; discount at cost of equity.
- ✓Cash conversion cycle = DSO + DIO − DPO, in days.
Exercises
Try each one on paper before revealing the worked solution.
Exercise 1
EBIT 90, tax 25%, D&A 30, capex 40, working capital up 15. What is FCFF?
Exercise 2
DSO 60, DIO 75, DPO 45, revenue 730 a year. How much cash is tied up in the cycle?