The Cash Flow Statement: Profit Isn't Cash

Profit ≠ cash

Revenue and profit are booked as soon as goods are sold, but the money may still be with the customer (accounts receivable). The cash flow statement tracks the actual cash coming in and going out, which is much harder to dress up than profit.

Free cash flow

operating cash flow minus capital expenditure is free cash flow: money the company can spend freely on dividends, buybacks or paying down debt. In the end, this is what valuation is about.

Three streams of cash

The cash flow statement has three parts: operating (cash in and out from the core business), investing (buying equipment, acquisitions) and financing (borrowing, repaying debt, dividends, buybacks). A healthy company funds investment and shareholder returns with operating inflows.

Key takeaways

• Operating cash flow = net income + depreciation − increase in receivables and inventory + increase in payables.
• Free cash flow = operating cash flow − capital expenditure. It's the money the company can truly spend as it wishes.
• Profit consistently above operating cash flow is often a warning sign, and cash flow propped up by delaying payments to suppliers is hard to sustain.

Try it yourself

You can do these exercises in this lesson's interactive simulation:

1. Switch to “Fast growth, slow collection”: net income is 1M, so what's operating cash flow? Which step drags it down the most?
2. In this preset, drag the increase in receivables back to 100K: what do operating cash flow and free cash flow become?
3. Switch to “Asset-heavy expansion”: operating cash flow looks fine, but what's free cash flow? Where did the money go?
4. Switch to “Cash cow” and drag the increase in accounts payable from 150K to 1M: how much did operating cash flow rise? Can this kind of “good” last?

Quiz and explanations

1. Net income is $100, but accounts receivable rose by $150, with nothing else changing. Roughly what's operating cash flow?

Answer: −$50.$100 − $150 = −$50: the profit is still sitting with customers, uncollected.

2. Free cash flow equals…

Answer: Operating cash flow − capital expenditure.After subtracting the investment needed to maintain and grow the business, what's left is the free money.

3. Net income $200, depreciation $50, inventory up $80, accounts payable up $30, capital expenditure $120. What's free cash flow?

Answer: $80.Operating cash flow = 200 + 50 − 80 + 30 = $200; minus $120 of capital expenditure leaves free cash flow of $80.

Terms in this lesson

• capital expenditure (Capital Expenditure): Spending on long-term assets like plants and equipment to maintain and grow the business.
• cash flow statement (Cash Flow Statement): How much cash actually came in and went out over a period, split into operating, investing and financing.
• depreciation (Depreciation): Spreading the cost of a long-term asset like equipment over its useful life; it's recorded as an expense but needs no further cash.
• free cash flow (Free Cash Flow): Operating cash flow minus capital expenditure: money the company can use for dividends, buybacks or paying down debt.
• operating cash flow (Operating Cash Flow): The cash the core business actually brings in, harder to dress up with accounting tricks than net income.
• accounts receivable (Accounts Receivable): Goods sold but not yet paid for; growing too fast can mean trouble collecting cash.