The cash flow statement reports the cash inflows and outflows of a business over a specific period. It is one of the three primary financial statements, alongside the income statement and the balance sheet, and is required for most UK companies under FRS 102.
Section 1: Why the Cash Flow Statement Matters
1.1 Profit Does Not Equal Cash
A business can report a healthy profit on its income statement while simultaneously running out of cash. This happens because accrual accounting records revenue when earned and expenses when incurred, regardless of when cash actually changes hands.
For example, a company might recognise £500,000 in revenue but only have collected £350,000 from customers, with £150,000 still outstanding as receivables. The cash flow statement bridges this gap by showing the actual cash position.
1.2 Assessing Liquidity
The cash flow statement reveals whether a business can:
- Pay its suppliers and employees on time
- Service its debt obligations
- Fund capital expenditure from operations
- Pay dividends to shareholders
- Survive without additional financing
1.3 Stakeholder Decisions
Lenders use the cash flow statement to assess whether a borrower can service debt. Investors use it to evaluate whether profits translate into real cash. Directors use it for working capital management and cash planning.
Section 2: Structure of the Cash Flow Statement
The cash flow statement is divided into three sections, each representing a different type of activity:
2.1 Cash Flows from Operating Activities
This section shows cash generated or consumed by the core business operations. It is generally the most important section because a sustainable business must generate positive operating cash flow.
Key items include:
- Cash received from customers
- Cash paid to suppliers and employees
- Interest paid
- Tax paid
- VAT payments or refunds
2.2 Cash Flows from Investing Activities
This section covers cash spent on acquiring or received from disposing of long-term assets:
- Purchase of property, plant and equipment
- Sale of fixed assets
- Purchase of intangible assets
- Acquisition of subsidiary companies
- Proceeds from sale of investments
Capital expenditure on assets subject to depreciation and amortisation appears here.
2.3 Cash Flows from Financing Activities
This section shows how the business raises and repays finance:
- Proceeds from issuing shares
- Proceeds from new bank loans or bonds
- Repayment of borrowings
- Payment of dividends
- Repayment of lease liabilities
Section 3: The Indirect Method
The indirect method is the most commonly used approach in UK financial reporting. It starts with profit before tax from the income statement and adjusts for non-cash items and changes in working capital to arrive at cash generated from operations.
3.1 Example Using the Indirect Method
| Item | £ |
|---|---|
| Profit before tax | 120,000 |
| Adjustments for: | |
| Depreciation | 25,000 |
| Amortisation | 8,000 |
| Loss on disposal of fixed assets | 3,000 |
| Interest expense | 10,000 |
| Changes in working capital: | |
| Increase in trade receivables | (15,000) |
| Decrease in inventory | 5,000 |
| Increase in trade payables | 8,000 |
| Cash generated from operations | 164,000 |
| Interest paid | (10,000) |
| Corporation tax paid | (25,000) |
| Net cash from operating activities | 129,000 |
3.2 Understanding the Adjustments
- Depreciation and amortisation are added back because they are non-cash charges that reduced profit but did not involve any cash outflow
- Loss on disposal is added back (gain would be deducted) because the cash from the disposal appears in investing activities
- Increase in receivables means cash has not yet been collected for some revenue, so it is deducted
- Decrease in inventory means the business has sold more stock than it bought, freeing up cash
- Increase in payables means the business owes more to suppliers, effectively retaining cash
Section 4: The Direct Method
The direct method reports actual cash receipts and payments from operations directly, without starting from profit.
4.1 Example Using the Direct Method
| Item | £ |
|---|---|
| Cash received from customers | 485,000 |
| Cash paid to suppliers | (220,000) |
| Cash paid to employees | (95,000) |
| Other operating cash payments | (6,000) |
| Cash generated from operations | 164,000 |
| Interest paid | (10,000) |
| Corporation tax paid | (25,000) |
| Net cash from operating activities | 129,000 |
Both methods produce the same net cash from operating activities. The direct method is more transparent but requires more detailed data.
Section 5: Complete Cash Flow Statement
| £ | |
|---|---|
| Cash flows from operating activities | |
| Net cash from operating activities | 129,000 |
| Cash flows from investing activities | |
| Purchase of property, plant and equipment | (80,000) |
| Proceeds from sale of equipment | 12,000 |
| Purchase of software | (15,000) |
| Net cash used in investing activities | (83,000) |
| Cash flows from financing activities | |
| Proceeds from new bank loan | 50,000 |
| Repayment of bank borrowings | (30,000) |
| Dividends paid | (20,000) |
| Net cash from financing activities | 0 |
| Net increase in cash and cash equivalents | 46,000 |
| Cash and cash equivalents at start of period | 30,000 |
| Cash and cash equivalents at end of period | 76,000 |
The closing cash balance of £76,000 should agree to the bank and cash balances on the balance sheet.
Section 6: FRS 102 Requirements
6.1 Who Must Prepare a Cash Flow Statement
Under FRS 102 Section 7, all entities preparing financial statements under FRS 102 must include a cash flow statement, with the exception of:
- Small entities applying Section 1A (the small company regime), which are exempt
- Qualifying entities applying the reduced disclosure framework under FRS 101
6.2 Classification
FRS 102 requires cash flows to be classified into operating, investing and financing activities. Interest and dividends may be classified in different ways:
| Item | FRS 102 classification |
|---|---|
| Interest paid | Operating or financing |
| Interest received | Operating or investing |
| Dividends paid | Financing |
| Dividends received | Operating or investing |
| Tax paid | Operating (unless specifically identified with investing or financing) |
The classification must be applied consistently from period to period.
6.3 Cash and Cash Equivalents
FRS 102 defines cash equivalents as short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to an insignificant risk of changes in value. Typically, investments with a maturity of three months or less from the date of acquisition qualify.
Bank overdrafts that are repayable on demand and form an integral part of cash management may be included as a component of cash and cash equivalents.
Section 7: Analysing the Cash Flow Statement
7.1 Free Cash Flow
Free cash flow is cash from operations minus capital expenditure. It represents the cash available to service debt, pay dividends and fund growth.
Free cash flow = Net cash from operating activities - Capital expenditure
Using the example above: £129,000 - £80,000 = £49,000
This is a key metric used by analysts and lenders when assessing business performance.
7.2 Cash Conversion Ratio
The cash conversion ratio measures how efficiently a business converts its operating profit into cash:
Cash conversion = Net cash from operating activities / Operating profit
A ratio above 100% indicates the business is collecting cash faster than it records profit, which is a positive sign. A consistently low ratio may signal problems with receivables collection or inventory management.
7.3 Trends Over Time
Comparing cash flow statements over several periods reveals important trends:
- Is operating cash flow growing in line with revenue and profit?
- Is the business increasing or decreasing capital expenditure?
- Is the business taking on more debt or repaying it?
- Are dividends sustainable relative to cash generation?
These financial ratios provide deeper insight when analysed alongside the cash flow statement.
Section 8: Common Pitfalls
8.1 Ignoring Working Capital Changes
A business might generate strong operating profit but consume cash through increasing receivables (slow-paying customers) or rising inventory levels. The cash flow statement highlights these working capital drains.
8.2 Confusing Capital Expenditure with Revenue Expenditure
If a capital item is wrongly expensed, it affects both the income statement and the operating cash flow section. Correct classification ensures investing activities reflect true capital spending.
8.3 Non-Cash Transactions
Some significant transactions do not involve cash and therefore do not appear in the cash flow statement. Examples include:
- Acquiring an asset through a finance lease
- Converting debt into equity
- Non-cash distributions to shareholders
FRS 102 requires disclosure of these transactions in the notes if they are material.
Section 9: The Cash Flow Statement in Context
The cash flow statement works alongside the other financial statements to give a complete picture:
- The income statement shows profitability on an accrual basis
- The balance sheet shows financial position at a point in time
- The cash flow statement shows how cash moved during the period
Together, these three reports allow stakeholders to assess whether a business is profitable, solvent and liquid. The trial balance provides the underlying data from which all three are prepared, and the audit provides independent assurance that they are reliable.
For a broader understanding of how these reports fit together, see our article on accounting fundamentals.