Why a cash flow statement matters.
P&L tells you whether you were profitable on accrual basis. Balance sheet tells you the position at a point in time. Neither tells you how cash actually moved during the period. A profitable business can run out of cash if growth absorbs working capital faster than profit generates it. A loss-making business can have positive cash flow if depreciation is high and working capital is releasing. Cash flow statement reconciles all this.
The statement has three sections: operating activities (cash from running the business), investing activities (cash from buying or selling fixed assets and investments), financing activities (cash from raising or repaying debt and equity). Operating + Investing + Financing = change in cash. The change in cash reconciles to opening and closing bank balance. If it does not, the statement is wrong.
The indirect method, the standard.
Indirect method starts with net profit and adjusts for non-cash items and working capital changes. The output is cash from operations. Adjustments include adding back depreciation (non-cash expense), adding back impairments and provisions, adjusting for gains and losses on asset sales, and adjusting for changes in working capital (increase in AR is cash used; decrease in AP is cash used; etc.).
Worked example: net profit $4.2M. Add back depreciation $1.2M. Add back bad debt provision $0.3M. AR increased from 10M to 12.5M, cash used $2.5M. Inventory increased from 16M to 18.7M, cash used $2.7M. AP increased from 7.5M to 9.4M, cash provided $1.9M. Cash from operations: 4.2 + 1.2 + 0.3 - 2.5 - 2.7 + 1.9 = $2.4M. Most of profit was absorbed by working capital growth.
The direct method, the clearer view.
Direct method shows actual cash receipts and payments by category. Cash received from customers (gross sales adjusted for AR change). Cash paid to suppliers (gross purchases adjusted for AP change). Cash paid for salaries. Cash paid for rent and utilities. Cash paid for taxes. Cash paid for interest. The total of cash receipts minus cash payments equals cash from operations. Same number as indirect method, different presentation.
Why direct is clearer: an owner can see exactly where the money came from and where it went, in plain operational categories. Why indirect is more common: it is easier to prepare from the existing books because every adjustment derives from balance sheet movements. Most accounting software defaults to indirect; preparing direct requires a more detailed transaction analysis.
Investing and financing sections.
Investing activities cover purchases and sales of long-term assets. Bought a delivery van for $2.4M: cash used in investing 2.4M. Sold an old van for $350,000: cash from investing 350,000. Net investing for the period: -2.05M. If you make a long-term investment in another company or in fixed deposits, that is also investing.
Financing activities cover capital raised, capital repaid, and dividend distributions. Took a long-term loan of $3M: cash from financing 3M. Repaid principal of $0.6M during the year: cash used in financing 0.6M. Owner withdrew $1.5M as drawings: cash used in financing 1.5M. Net financing 0.9M.
Total cash flow: Operating 2.4M + Investing -2.05M + Financing 0.9M = 1.25M. Compare to actual change in bank balance during the year (closing minus opening, including the offset of cash on hand). Should match exactly. If it does not, the statement is wrong somewhere.
When direct method tells the better story.
For SMB owners reading their own books, direct method is more intuitive. "Customers paid us $88M; we paid suppliers $58M; we paid salaries $14M; we paid taxes $1.1M..." reads like an operational summary. Indirect method reads like an accountant's reconciliation. For internal management discussion, especially with non-finance owners, direct is more useful.
For external audiences (banks, investors, auditors), indirect method is the standard expected format. banks reviewing loan applications expect indirect method statements. Auditors prepare indirect method as part of statutory financial statements. So the answer is often "both": prepare both, use direct for internal review, use indirect for external presentation.
A worked annual cash flow.
Distribution SMB, fiscal year ended June 30, 2026. Net profit 4.2M. Indirect method: add back depreciation 1.2M, bad debt provision 0.3M, inventory write-down 0.2M. Adjust for AR increase -2.5M, inventory increase -2.7M, AP increase +1.9M, accrued expenses +0.4M. Cash from operations: 3.0M.
Investing: bought fixed assets -2.4M, sold old van +0.35M. Net investing -2.05M. Financing: long-term loan drawn +3.0M, principal repaid -0.6M, owner drawings -1.5M. Net financing +0.9M. Total cash flow: 3.0 - 2.05 + 0.9 = 1.85M.
Opening cash and bank: 4.15M. Closing cash and bank: 6.0M. Difference: 1.85M. Matches the cash flow statement total. Statement is correctly prepared.
Common errors and how banks spot them.
Error one: cash flow does not reconcile to balance sheet movement. Usually a missing or misclassified item. Check sign conventions; an AR increase reduces cash, an AR decrease provides cash. Easy to mix up. Error two: classifying interest as financing instead of operating. banks expect interest paid in operating activities (under IFRS for SMEs allowed treatment). Interest received and dividends received also operating typically.
Error three: classifying capex within operating instead of investing. Buying a building or vehicle is investing, never operating, regardless of how it was financed. Error four: showing dividends as operating outflow. Dividends are financing. Error five: gross vs net presentation: cash from sale of an asset should be the proceeds, not the gain or loss. The gain or loss is a P&L item; the cash flow line is the actual cash received.
- Cash flow ties to balance sheet movement.
- Interest paid in operating section.
- Capex always in investing.
- Dividends and drawings in financing.
- Asset sale shows gross proceeds.
Using cash flow for decisions.
A profitable business with weak operating cash flow needs working capital attention. Either DSO is too high, or DIO is too high, or both. The cash flow statement quantifies the trapped capital. A 10-day DSO reduction on $90M revenue releases $2.5M of cash, which is often more than a year of profit improvement initiatives.
Free cash flow = Operating cash flow - Capex. In our example: 3.0M - 2.4M = 0.6M. Free cash flow is what remains for repaying debt, paying dividends, or investing in growth. If free cash flow is negative for multiple periods, the business is consuming cash, regardless of accounting profit. Bank loan applications hinge more on free cash flow than on net profit. Owners who do not track free cash flow are surprised when banks decline credit despite a positive P&L.