How to read a cash flow statement

Key takeaways

• The cash flow statement splits cash movements into operating (CFO), investing (CFI) and financing (CFF) activities, which together equal the change in cash.
• The indirect method starts at net income, adds back non-cash items, removes non-operating gains and adjusts for working capital changes; the direct method lists gross cash receipts and payments. Both produce the same CFO.
• Free cash flow is commonly CFO less capital expenditure. It is a non-GAAP measure, so the definition must be stated.
• FCFF is cash available to all capital providers before financing flows; FCFE is cash available to shareholders after interest and net borrowing.
• FCFF = CFO + interest x (1 - t) - capex, and FCFE = FCFF - interest x (1 - t) + net borrowing, when interest paid sits in CFO.
• IFRS lets companies place interest and dividends in different sections, so CFO is not comparable across frameworks without adjustment.

The three sections

Cash flow from operating activities (CFO) captures the cash effects of the company's principal revenue-producing activities: collecting from customers, paying suppliers and employees, and, under US GAAP, paying interest and taxes. It is the best single measure of whether the core business generates or consumes cash.

Cash flow from investing activities (CFI) captures the acquisition and disposal of long-term assets and investments: capital expenditure on property and equipment, purchases of businesses, purchases and sales of securities not held as cash equivalents, and the proceeds from selling equipment. For most healthy operating companies CFI is negative, because they reinvest.

Cash flow from financing activities (CFF) captures transactions with the providers of capital: borrowing and repaying debt, issuing and repurchasing shares, paying dividends and, under both ASC 842 finance leases and IFRS 16, repaying the principal portion of lease liabilities. Its sign depends on whether the company is raising capital or returning it.

The statement also discloses significant non-cash investing and financing activities, such as converting debt to equity or acquiring an asset in exchange for a note, which change the balance sheet without any cash flow. The totals must satisfy one identity: CFO plus CFI plus CFF, plus any effect of exchange rate changes on cash, equals the change in cash between the two balance sheets.

Lakeshore Logistics: the income statement and balance sheet movements

Lakeshore Logistics is a hypothetical company used throughout this topic. Figures are in $m for one year, with a 25 percent tax rate. Its income statement shows revenue of 900, cost of goods sold of 540, SG&A of 184 (which includes 10 of stock-based compensation, a non-cash expense), and depreciation and amortization of 50. During the year it sold old equipment with a book value of 10 for 16 in cash, a gain of 6 recorded in operating income.

Operating income (EBIT) is 900 - 540 - 184 - 50 + 6 = 132. Interest expense of 20, all paid in cash, leaves pretax income of 112. Tax expense is 28, of which 23 is current tax paid in cash and 5 is deferred tax. Net income is 84.

On the balance sheet, receivables rose 20, inventory rose 15, accounts payable rose 12, accrued liabilities rose 4 and deferred revenue rose 3. Lakeshore spent 90 on capital expenditure and 30 on acquiring a small business. It borrowed 60 of new debt, repaid 25, paid dividends of 20 and bought back 15 of stock. Opening cash was 37.

The indirect method: reconciling net income to cash

The indirect method, used by the great majority of companies under both US GAAP and IFRS, starts with net income and makes three kinds of adjustment. First, add back non-cash expenses: depreciation and amortization, stock-based compensation, deferred tax expense, impairments and similar items. Second, remove gains and add back losses on items whose cash belongs in another section; the proceeds from selling equipment are an investing inflow, so the gain inside net income must be taken out of operating cash flow to avoid counting it twice. Third, adjust for changes in operating working capital.

The working capital rule follows from the accounting equation. An increase in an operating asset (receivables, inventory, prepaids) means cash was tied up, so it is subtracted. An increase in an operating liability (payables, accruals, deferred revenue) means cash was retained, so it is added. Decreases reverse the signs.

The direct method

The direct method reports operating cash flow as gross categories of cash received and paid: cash from customers, cash paid to suppliers, cash paid to employees and for other operating costs, interest paid and taxes paid. Standard setters on both sides encourage it because it is easier to understand, but few companies use it, and under US GAAP a company that does must still present the indirect reconciliation as well.

Analysts can rebuild the direct method from the income statement and balance sheet. Each income statement line is converted to cash by adjusting for the working capital account that relates to it and removing non-cash items. The exercise is valuable in diligence because it shows which part of the business is consuming cash: a rising gap between revenue and cash from customers points to collection problems, not margin problems.

Investing and financing activities in practice

Capital expenditure is the largest investing item for most companies, and it is worth splitting in analysis into maintenance capex, the spending needed to sustain current capacity, and growth capex, spending to expand it. Companies rarely report the split, so it is an estimate; depreciation is sometimes used as a rough proxy for maintenance capex, which is reasonable only when asset prices and the asset base are stable.

Acquisitions are reported net of cash acquired. Proceeds from asset sales appear here at their full cash amount, which is why any gain was removed from CFO. Purchases and sales of marketable securities can make CFI swing widely for cash-rich companies without saying anything about the operating business.

In financing, look at the gross flows, not only the net. Lakeshore's CFF of zero hides $60m of new borrowing that funded $35m of shareholder returns and $25m of repayment. A company funding dividends and buybacks with new debt is changing its capital structure even if CFF nets to nothing.

Free cash flow, FCFF and FCFE: definitions

Free cash flow is not defined by US GAAP or IFRS, so each user must state a definition. Three are standard.

Free cash flow (FCF), as most companies and screening tools use the term, is CFO less capital expenditure. It is simple and it is levered: because interest paid is already inside CFO under US GAAP, it measures cash left for shareholders before any borrowing or repayment.

Free cash flow to the firm (FCFF), also called unlevered free cash flow, is the cash generated by operations after taxes and reinvestment, before any payment to lenders or shareholders. It is independent of capital structure, so it is discounted at the weighted average cost of capital to give enterprise value. Because the tax figure is computed as if the company had no debt, the tax shield from interest is excluded; it is captured instead through the after-tax cost of debt in the discount rate.

Free cash flow to equity (FCFE), also called levered free cash flow, is the cash available to common shareholders after interest, after tax and after net borrowing. It is discounted at the cost of equity to give equity value. Practitioner usage varies: some analysts use 'levered free cash flow' for cash flow after interest but before any new borrowing or repayment, which is simply FCF above. State which one you mean.

Worked: FCF, FCFF and FCFE for Lakeshore

The three measures for Lakeshore are computed below from the same facts. Two cross-checks confirm the arithmetic: FCFF computed from EBIT equals FCFF computed from CFO, and FCFE computed from FCFF equals FCFE computed from CFO. The equipment sale proceeds and the acquisition are excluded from all three, following the common convention that free cash flow measures the ongoing business. Some analysts include disposal proceeds; either is defensible if stated.

US GAAP and IFRS classification choices

US GAAP (ASC 230) is prescriptive. Interest paid, interest received and dividends received are operating cash flows. Dividends paid are financing. Income taxes are operating.

IFRS (IAS 7, before the amendments made by IFRS 18) offers choices that must be applied consistently. Interest paid may be operating or financing. Interest received and dividends received may be operating or investing. Dividends paid may be operating or financing. Taxes are operating unless specifically identified with investing or financing activities. IFRS 18, effective for annual periods beginning on or after 1 January 2027, amends IAS 7 to remove most of these choices for companies whose main business is not investing or providing finance: interest and dividends received go to investing, and interest and dividends paid go to financing. Until then, and for comparatives, check the accounting policy note.

The practical consequence is that CFO and any free cash flow built from it can differ between two economically identical companies. An IFRS reporter that puts interest paid in financing reports higher CFO, and its 'CFO minus capex' is closer to an unlevered measure than a levered one.