Preparing Cash Flows Practically: How to Extract Them from the Balance Sheet and Income Statement? (Step by Step)
Preparing Cash Flows Practically: How to Extract Them from the Balance Sheet and Income Statement? (Step by Step)
“Profit is an opinion, Cash is a fact.” A company can show massive profits on paper yet go bankrupt because it ran out of cash to pay salaries. This is why the Statement of Cash Flows is crucial. It ignores accounting accruals and focuses solely on the movement of money. In this guide, we explain how to prepare this statement under IAS 7: What are the three activities (Operating, Investing, Financing)? And how to use the Indirect Method to convert Net Profit into Net Cash.
- Definition of the Statement of Cash Flows and “Cash Equivalents.”
- Why Net Profit ≠ Net Cash Flow (Understanding Non-cash items).
- Detailed breakdown of the 3 Activities: Operating, Investing, and Financing.
- Comparison: Direct Method vs. Indirect Method.
- Visual model (SVG) explaining the Indirect Method adjustments logic.
- Interactive Tool: Calculate Operating Cash Flow from Net Income.
- What is Free Cash Flow (FCF) and why do investors love it?
1) What is the Statement of Cash Flows?
It is a financial statement that summarizes the amount of cash and cash equivalents entering and leaving a company.
2) The Three Pillars (Activities)
IAS 7 requires classifying cash flows into three categories:
| Activity | Definition | Examples (In/Out) |
|---|---|---|
| Operating | Principal revenue-producing activities. | + Cash from Customers – Payments to Suppliers/Staff |
| Investing | Acquisition/disposal of long-term assets. | + Sale of Equipment – Purchase of Land |
| Financing | Changes in equity and borrowings. | + Issuing Shares/Loans – Paying Dividends |
3) Direct vs. Indirect Method
How do we calculate “Cash from Operations”? There are two ways:
13-Week Cash Forecast - Excel Template
- Direct Method: Lists major classes of gross cash receipts and payments (e.g., “Cash paid to suppliers”). It is more transparent but harder to prepare.
- Indirect Method: Starts with Net Profit and adjusts for non-cash items and changes in working capital. This is the most common method used globally.
4) Visual Logic: The Indirect Method
5) Practical Example (Indirect Calculation)
| Net Income | $100,000 |
| + Depreciation Expense | $20,000 |
| – Increase in Receivables | ($10,000) |
| + Increase in Payables | $5,000 |
| = Net Cash from Operations | $115,000 |
Note: An increase in assets (Receivables) consumes cash (Negative), while an increase in liabilities (Payables) saves cash (Positive).
6) Interactive Cash Flow Calculator
Estimate your Operating Cash Flow using the Indirect Method:
7) Free Cash Flow (FCF)
Free Cash Flow is the cash left over after paying for operating expenses and capital expenditures (CAPEX).
8) Frequently Asked Questions
Why add back depreciation?
Depreciation is deducted to calculate Net Profit, but it does not involve a cash outflow. Therefore, we add it back to reflect the actual cash position.
Is Interest Paid Operating or Financing?
Under IAS 7, there is flexibility. Interest paid can be classified as either Operating or Financing, provided it is applied consistently.
9) Conclusion
The summary is simple: The Statement of Cash Flows is the truth serum of accounting. While profits can be manipulated by estimates, cash flow is hard fact. By mastering the Indirect Method and understanding the three activity pillars, you can assess the true survival capability and value generation of any business.