The cash flow statement is the hardest of the three to fake, because cash either moved or it didn't. It reconciles the income statement (which uses accruals) to the actual cash that hit the bank. Three sections, in order:
Operating activities
Cash from running the business. The standard layout starts with net income and adjusts for:
- Add back non-cash expenses: depreciation, amortization, stock-based compensation
- Adjust for changes in working capital: AR up = cash out, AP up = cash in, inventory up = cash out
- Add back losses or subtract gains on asset sales (those flow through investing instead)
The result is cash flow from operations (CFO). For most healthy mature businesses, CFO should track net income reasonably closely over time. Big persistent gaps deserve scrutiny.
Investing activities
Cash spent buying or selling long-term assets:
- Capital expenditures (capex) — usually the biggest line, almost always negative
- Acquisitions and divestitures
- Purchase or sale of investments and securities
Capex tells you how much the business is reinvesting to maintain or grow its asset base. Mature businesses have predictable capex; growing ones have lumpy capex.
Financing activities
Cash exchanged with capital providers:
- Debt issued or repaid
- Equity issued or repurchased (buybacks)
- Dividends paid
Free cash flow — the most-quoted derived metric
Free cash flow
Free cash flow (FCF) = Cash from operations − Capital expenditures. It's the cash the business generates after maintaining its asset base — the money truly available to debt holders, equity holders, or reinvestment. The closest thing accounting gives you to 'what the business actually earned'.
Reading the statement together
A healthy business has positive CFO, negative investing (because it's reinvesting), and either positive or negative financing depending on its stage. A company with negative CFO covered by positive financing (issuing debt or stock) is funding its operations from outside capital — fine for a startup, alarming for a mature business.
The classic red flag
Net income growing while CFO declines is one of the strongest signals of earnings quality issues. The income statement says it earned more; the cash flow statement says less actually arrived. Always sanity-check one against the other.
Exercise
A company shows: Net income $100M, D&A $40M, AR increased by $20M, AP increased by $10M, Capex $50M. Compute CFO and FCF.