Demonstration article

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Company accounts usually contain three main statements. The income statement reports revenue, costs and profit over a period. The balance sheet records what the company owns and owes at a point in time. The cash-flow statement tracks the actual movement of cash in and out. Of the three, it is often the most revealing, because it is the least affected by accounting judgements about when revenue and costs should be recognised.

The three sections

Operating cash flow shows cash generated by the core business: money received from customers minus money paid to suppliers, employees and tax authorities. It usually starts with net profit and adjusts for non-cash items such as depreciation, and for changes in working capital — inventories, receivables and payables.

Investing cash flow captures spending on long-term assets such as factories, equipment and software, as well as acquisitions and the sale of assets. A growing company will typically show large outflows here. Financing cash flow records money raised from or returned to lenders and shareholders: new borrowing, debt repayments, share issues, buybacks and dividends.

A company can report a profit and still run out of money. The cash-flow statement is where that danger shows first.

What to look for

The first test is whether operating cash flow broadly tracks reported profit over time. A business that reports steadily rising profits while generating little cash deserves scrutiny. The gap may be innocent — a fast-growing firm investing in inventory, for example — but it can also signal aggressive revenue recognition or customers who are slow to pay.

Working capital tells its own story. Rising receivables relative to sales may mean customers are being given more generous terms to win business. Swelling inventories can indicate slowing demand. Conversely, a company that delays paying its suppliers will temporarily boost its operating cash flow, which flatters the figures without improving the underlying business.

Questions to ask of any cash-flow statement

Does operating cash flow keep pace with reported profit?

What is left after capital spending — the free cash flow?

Are dividends and buybacks funded by operations or by borrowing?

Are working-capital changes boosting or draining cash?

Do one-off asset sales disguise weak underlying performance?

Free cash flow and its uses

Many analysts focus on free cash flow: operating cash flow minus the capital spending needed to maintain and grow the business. It represents the cash a company could, in principle, return to its owners or use to reduce debt. Persistent negative free cash flow is not necessarily alarming in a young company investing for growth, but in a mature one it raises questions about how long its payouts can last. No single statement tells the whole story. But reading the three together, and asking where the cash actually comes from, is one of the most reliable ways for an investor, lender or employee to judge a company's financial health.