How the cash flow statement links to the balance sheet and income statement

How do the three statements fit together?

The balance sheet is a snapshot at one date. The other statements are flows: they explain how the snapshot changed between two dates.

• The income statement reports performance over the period on an accrual basis, so revenue and expenses are recorded when earned or incurred, not when cash moves.
• The statement of cash flows reports the change in cash, cash equivalents and restricted cash, sorted into three activities.
• The statement of changes in equity shows how share capital and retained earnings moved: net income in, dividends and buybacks out.

Profit and cash part ways in the working capital accounts. A credit sale raises revenue and receivables but not cash. Play it in the interactive: sell on credit, then collect, and watch where each entry lands.

Which activity does a cash flow belong to?

Three: operating, investing or financing. Operating is the day-to-day business, investing is long-term assets, and financing is how the company raises and returns capital.

Statement of cash flowsexplains the change in cash, cash equivalents and restricted cash

• Operating activities Memorize the day-to-day business
  • Cash received from customers
  • Cash paid to suppliers, employees and for other costs
  • Interest paid and received, taxes paid, dividends received
• Investing activities Memorize buying and selling long-term assets
  • Property, plant and equipment and intangibles bought and sold
  • Securities of other companies stocks and bonds bought and sold
  • Loans made to others and repayments received
• Financing activities Memorize raising and returning capital
  • Debt issued and repaid
  • Own shares issued and bought back
  • Dividends paid

Operating activities cover cash from customers and payments to suppliers, employees and the tax authority. Under US generally accepted accounting principles (GAAP) they also include interest paid, interest received and dividends received. Investing activities cover buying and selling property, plant and equipment, intangibles and securities of other companies, and lending to others. Financing activities cover debt and equity raised or repaid, plus dividends paid.

Cash flow	Section (US GAAP)
Collection from a customer	Operating
Interest paid on a loan	Operating
Purchase of a factory machine	Investing
Purchase of a government bond held long term	Investing
Repayment of loan principal	Financing
Share buyback	Financing
Dividend paid to shareholders	Financing

Exam tip Interest is the odd one out: the loan principal is financing, but the interest on it is operating under US GAAP.

How does a balance sheet account roll forward?

Opening balance, plus what the income statement added, minus what was settled in cash, equals the closing balance. Rearrange it and the cash figure drops out.

$$B_{end} = B_{begin} + \text{additions} - \text{deductions}$$

For receivables, the addition is revenue on credit and the deduction is cash collected. This is the accounts receivable roll-forward .

Inventory and payables follow the same logic. In the inventory roll-forward , purchases are the addition and cost of goods sold (COGS) is the deduction. In the accounts payable roll-forward , purchases on credit are the addition and cash paid to suppliers is the deduction.

$$\text{Purchases} = \text{COGS} + B_{end} - B_{begin}$$

Go deeper Why working capital separates profit from cash

Every operating account that sits between a sale or an expense and the cash receipt or payment is a working capital account: receivables, inventory, prepaid expenses, payables, wages payable, taxes payable and unearned revenue. When these accounts change, profit and cash differ. The indirect method (lesson 2) corrects net income for every one of these changes; the direct method (lesson 3) converts each income statement line to cash with its own account.

Go deeper Restricted cash

The statement explains the change in cash, cash equivalents and restricted cash together (US GAAP requires restricted cash to be included in the totals). Cash equivalents are short-term, highly liquid investments that are close to maturity (original maturity of about three months or less). Restricted cash is cash the company cannot use freely, such as escrow. Companies reconcile the statement to the balance sheet lines.

What about deals that involve no cash?

Leave them out of the statement and disclose them. Examples are converting debt into shares, acquiring an asset with a finance lease, acquiring an asset by issuing shares, and exchanging one non-cash asset for another. These non-cash transactions change the balance sheet but not cash, so they never appear in operating, investing or financing totals.

Exam tip If a question says “the company issued shares to acquire a building”, the answer is “not in the statement”.