The Report That Tells You the Truth
Of the three main financial statements, the cash flow statement is the one most owners skip. The balance sheet and the profit and loss account get all the attention, and the cash flow statement is left to sit at the back of the accounts like an appendix nobody reads.
That is a mistake, because the cash flow statement is the one report that is very hard to dress up. Profit involves judgement. You can decide when to recognise income, how fast to depreciate an asset, what to accrue. Cash is blunter. The money either moved or it did not. When an owner wants to know whether a business is actually healthy, the cash flow statement is where we look first.
This guide explains what a cash flow statement is in plain English, walks through its three sections, shows a worked example, and clears up the two ways it can be prepared. Once you can read it, the gap between your profit figure and your bank balance stops being a mystery.
What a Cash Flow Statement Actually Is
A cash flow statement, sometimes called the statement of cash flows, is a report that shows every pound of cash that moved into and out of a business over a period, and groups those movements by what caused them.
It answers a simple question that the other two statements cannot answer on their own: where did the cash come from, and where did it go? The profit and loss account tells you whether you made a profit. The balance sheet tells you what you owned and owed on one day. The cash flow statement is the only one that explains how your bank balance got from where it was at the start of the year to where it is now.
The reason this matters is the same reason we keep coming back to in our working capital guide: profit and cash are not the same thing. You can make a sale and book the profit today, but if the customer pays in 60 days, the cash is not there yet. You can buy a van for £20,000 and the cash leaves immediately, but only a slice of it shows up as depreciation on the P&L this year. The cash flow statement is built precisely to reconcile those differences.
The Three Sections
Every cash flow statement splits cash movements into three buckets. This structure is set by accounting standards, and once you know the three, you can read any cash flow statement in the country.
Operating activities. This is the cash generated or consumed by the day to day running of the business: cash from customers, less cash paid to suppliers, staff and HMRC. For most businesses this is the section that matters most, because it shows whether the core trade actually produces cash. A business can prop itself up for a while by selling assets or borrowing, but if operating cash flow is consistently negative, the engine is not working.
Investing activities. This covers cash spent on or received from longer-term assets: buying equipment, vehicles or property, and the cash that comes back when you sell them. A growing business often shows negative investing cash flow, because it is buying fixed assets to expand. That is not a bad sign on its own. It is investment.
Financing activities. This is cash moving between the business and the people who fund it: new bank loans coming in, loan repayments going out, money the owner puts in, and dividends or director's remuneration taken out. It shows how the business is funded and what it is returning to its backers.
Add the three sections together and you get the net change in cash for the period. Add that to the cash you started with, and you arrive at the cash you ended with, which should tie exactly to the bank figure on your balance sheet. That tie is the whole point. The cash flow statement is the bridge between the two dates on your balance sheet.
A Worked Example
Numbers make this concrete. Take a small trading company over one year. It made a profit of £40,000 on its P&L, yet the owner noticed the bank balance barely moved. The cash flow statement explains why.
Operating activities:
- Net profit: £40,000
- Add back depreciation (a non-cash cost): £8,000
- Increase in trade receivables (customers owe more, so less cash in): −£15,000
- Increase in stock (cash tied up in goods): −£10,000
- Increase in trade payables (suppliers funding you, so more cash kept): +£6,000
- Net cash from operating activities: £29,000
Investing activities:
- Bought a new van: −£20,000
- Net cash used in investing activities: −£20,000
Financing activities:
- New bank loan: +£15,000
- Dividends paid to the owner: −£18,000
- Net cash from financing activities: −£3,000
Net change in cash: £29,000 − £20,000 − £3,000 = £6,000.
So a business that reported £40,000 of profit added only £6,000 to its bank account. Nothing has gone wrong. The cash flow statement shows exactly where the other £34,000 went: £25,000 was swallowed by growth in receivables and stock, £20,000 bought a van that will earn its keep for years, and £18,000 went out as dividends, partly offset by the loan and the depreciation add-back. None of that is visible on the profit and loss account, and that is the gap the statement exists to close.
The Direct and Indirect Method
There are two ways to prepare the operating activities section, and the difference confuses a lot of people, so it is worth a plain explanation.
The indirect method starts with your net profit and adjusts it back to cash. You add back non-cash costs like depreciation, then adjust for the changes in working capital: more money tied up in receivables and stock reduces cash, more owed to suppliers increases it. Our worked example above uses the indirect method. It is the version you will see in the vast majority of UK company accounts, because it links straight to the figures already on the P&L and balance sheet and is quick to produce.
The direct method ignores the profit figure and simply lists the actual cash flows: cash received from customers, cash paid to suppliers, cash paid to staff, and so on. It is arguably clearer to read, because it shows real money movements rather than a reconciliation, but it takes more work to pull together from the accounting records, so it is rarely used in practice.
Both methods produce exactly the same net cash from operating activities. They are two routes to the same number. If you are reading your own accounts, you will almost certainly be looking at the indirect method, which is why understanding the accruals concept and how working capital moves is the key to making sense of it.
How to Actually Read One
When we sit down with an owner and a cash flow statement, we are looking for a few things, and you can look for the same.
Start with operating cash flow, not the bottom line. The single most important number is net cash from operating activities. Is the core business generating cash? Compare it to the profit figure. If profit is healthy but operating cash flow is weak or negative, cash is being trapped somewhere, usually in receivables or stock, and that is a working capital problem worth chasing.
Check what is funding the business. If the bank balance went up, look at why. Cash rising because the trade is throwing off money is very different from cash rising because the owner injected a loan or stopped paying suppliers. The first is strength. The second is borrowed time. The three-section split is designed to make this visible at a glance.
Watch the trend, not the single year. One year of negative investing cash flow means the business invested. Three years of negative operating cash flow means the business is slowly bleeding. A cash flow statement read in isolation tells you far less than three of them read side by side.
Our View: It Is the Honest Statement, So Use It
In our experience, the cash flow statement is the most under-used document in a small company's accounts, and that is a shame, because it is the hardest one to fool yourself with.
Profit can flatter a business for a surprisingly long time. A company can report rising profits while quietly running out of cash, because the profit is locked up in unpaid invoices and growing stock. The net income figure looks great right up until the day there is nothing in the bank to pay the VAT. The cash flow statement is the early warning, because it strips out the accounting judgement and shows the money as it actually moved.
Our real recommendation goes one step further. The statutory cash flow statement in your year-end accounts is a look in the rear-view mirror. The version that protects a business is a forward-looking one: a simple rolling forecast of cash in and cash out over the next few months. Build that, update it weekly, and a cash squeeze announces itself in good time rather than arriving as a nasty surprise. Profit is an opinion formed once a year. Cash is a fact you have to face every week, and the cash flow statement, especially a forward-looking one, is how you face it honestly.
How IAK Can Help
We help owners read their cash flow statement and, more importantly, act on it. Clean bookkeeping keeps the underlying figures accurate, management reporting turns the statement into a forward-looking cash forecast you can plan around, and our accounting work produces a full set of year-end statements, including a cash flow statement, that ties together and that you can trust.
If your profit and your bank balance have never quite seemed to agree, the cash flow statement is where that mystery gets solved. Contact us for a straight conversation about your numbers.
Sources
- IAS 7 Statement of Cash Flows sets out the three-section structure and both the direct and indirect methods. Published by the IFRS Foundation.
- FRS 102 Section 7, the cash flow statement requirements for most UK small and medium companies, published by the Financial Reporting Council.
- GOV.UK guidance on annual accounts for limited companies, including which statements smaller companies must file.