How to Build a Cash Flow Statement

If your company is profitable on paper but the bank balance doesn't reflect it, the cash flow statement is the report that explains the difference. It shows where cash actually came from and where it went during a period, which the income statement does not.

You build a cash flow statement by starting with net income, adjusting it for non-cash expenses and changes in working capital to get operating cash flow, then adding the cash effects of investing and financing activities. The total is the net change in cash for the period. Added to beginning cash, it has to equal the cash balance on your ending balance sheet.

This post covers the structure, the inputs, the indirect method step by step, and a full worked example.

The statement has three sections

Every cash flow statement prepared under US GAAP groups cash movements into three categories.

Operating activities. Cash generated or used by running the business: collecting from customers, paying suppliers and employees, paying interest and income taxes. This is the section that shows whether the core business produces cash.

Investing activities. Cash spent on or received from long-term assets: buying equipment, purchasing or selling investments, acquiring another business. Capital expenditure lands here.

Financing activities. Cash exchanged with lenders and owners: loan proceeds and repayments, equity raised, dividends or owner distributions paid.

Under US GAAP, interest paid and interest received are classified as operating activities. Dividends paid are financing. This differs from IFRS, which allows more choice, so a US company should follow the US classification.

You need three documents before you start

The cash flow statement is built from reports you already have. It is not a separate set of records.

The income statement for the period. This provides net income, depreciation and amortization, and any gains or losses on asset sales.

The balance sheet at the start of the period. This is the prior period's ending balance sheet.

The balance sheet at the end of the period. The change in each account between the two balance sheets drives most of the statement.

You will also want the detail behind any large balance sheet movements, such as the loan agreement for new borrowing or the invoice for an equipment purchase, so you can classify each one correctly.

Most companies use the indirect method

US GAAP permits two ways to present operating cash flow.

The direct method lists actual cash receipts and payments: cash collected from customers, cash paid to suppliers, cash paid to employees. It is easier to read, but most accounting systems don't track cash this way, so it takes more work to prepare. A company using the direct method must still include a reconciliation of net income to operating cash flow.

The indirect method starts with net income and adjusts it back to cash. It uses data that comes straight from the income statement and balance sheet, which is why most companies use it. The rest of this post uses the indirect method.

Only the operating section differs between the two. Investing and financing are presented the same way under both.

Operating cash flow starts with net income

Net income includes items that didn't involve cash, and it excludes cash movements that haven't hit the income statement yet. The adjustments correct for both.

Add back non-cash expenses. Depreciation and amortization reduce net income but no cash leaves the business. Stock-based compensation works the same way.

Remove gains and add back losses on asset sales. The full sale proceeds appear in investing activities, so the gain or loss is taken out of operating cash flow to avoid counting it twice.

Adjust for changes in working capital. This is where most of the work is, and one rule covers every account:

• An increase in a current asset (accounts receivable, prepaid expenses, inventory) is subtracted. Cash is tied up in it.
• A decrease in a current asset is added. Cash was released.
• An increase in a current liability (accounts payable, accrued expenses, deferred revenue) is added. You held on to cash you will pay or earn later.
• A decrease in a current liability is subtracted. Cash went out to settle it.

A company with rising receivables can report strong net income and weak operating cash flow at the same time. The working capital adjustments are what make that visible.

Investing and financing come from long-term balance sheet changes

Once operating activities are done, the remaining balance sheet movements are mostly long-term.

Fixed assets. An increase in gross property and equipment is usually cash spent on purchases and goes in investing as an outflow. Use the gross figure, not the net figure, since the change in accumulated depreciation is already captured by the depreciation add-back.

Investments. Purchases of investments are outflows and sales are inflows, both in investing.

Debt. New borrowing is a financing inflow and repayments are a financing outflow. Show them separately rather than netting them, so a reader can see both.

Equity. Cash from issuing stock is a financing inflow. Dividends or owner distributions are a financing outflow. The change in retained earnings is explained by net income (already in operating) and dividends (in financing), so it doesn't need its own line.

A worked example from start to finish

Take a services company with the following results for the year.

Income statement

Balance sheet changes

The loan movement is $50,000 of new borrowing and $20,000 of repayments. The company also paid $15,000 in dividends during the year.

Cash flow statement for the year

The company earned $150,000 and generated $175,000 from operations. Most of the difference came from customers prepaying (deferred revenue) and the company paying its own bills more slowly, which more than offset the $40,000 tied up in new receivables. It then spent $60,000 on equipment and added a modest amount of net borrowing after dividends.

The ending cash has to tie to the balance sheet

The final line of the statement is the check on everything above it. Beginning cash plus the net change must equal the cash balance on the ending balance sheet. In the example, $80,000 plus $130,000 equals $210,000, which matches.

If it doesn't tie, the cause is almost always one of these.

A balance sheet account was left out. Every change on the balance sheet other than cash itself should appear somewhere on the statement, either directly or through net income. Walking through each account and ticking it off finds most gaps.

A sign was reversed. Treating an increase in receivables as an addition, or an increase in payables as a subtraction, is the most common error. It creates a gap of exactly twice the amount.

Depreciation was counted twice. Using net fixed assets for capital expenditure while also adding back depreciation double-counts it.

A non-cash transaction was treated as cash. Equipment bought with a loan, or debt converted to equity, changes the balance sheet without moving cash. These are disclosed separately and kept out of the three sections.

The statement depends on reconciled books

The cash flow statement doesn't create new information. It rearranges what is already on the income statement and the two balance sheets, so any error in those flows straight through. Unreconciled bank accounts, receivables that include payments already received, or accruals that were never recorded will all produce a statement that ties mathematically and still misstates where cash went.

Inkle's bookkeepers close your books every month, so the balance sheets and income statement your cash flow statement is built from are reconciled before you start. This works whether your books are on Inkle Books or on software you already use, such as QuickBooks or Xero.

The bottom line

A cash flow statement answers a question the income statement can't: whether the business is producing cash, and what it is doing with it. The indirect method gets there with data you already have, and the work is mostly in classifying balance sheet changes correctly. The tie-out to ending cash is a reliable check on the mechanics, but not on the underlying numbers. A statement built from unreconciled books will balance and still be wrong, so the quality of the monthly close matters more than the template.

Frequently asked questions

What is the difference between the cash flow statement and the income statement?

The income statement records revenue when it is earned and expenses when they are incurred, regardless of when cash moves. The cash flow statement records only actual cash in and out. A company can be profitable and still run short of cash if customers pay slowly or capital spending is high.

Do small businesses need to prepare a cash flow statement?

There is no general federal requirement for a private company to prepare one. It is required for a full set of GAAP financial statements, so lenders, investors, and auditors will usually ask for it. Many owners also use it internally to track whether the business is generating cash.

Is the indirect method or direct method better?

Both are acceptable under US GAAP and produce the same operating cash flow total. The indirect method is far more common because it uses data already in the income statement and balance sheet. The direct method is easier for non-accountants to read but takes more effort to prepare and still requires a net income reconciliation.

Where does interest go on the cash flow statement?

Under US GAAP, interest paid and interest received are both operating activities. Repaying loan principal is a financing activity. Dividends paid are also financing.

Why is depreciation added back on the cash flow statement?

Depreciation reduces net income but doesn't involve any cash leaving the business that year. The cash went out when the asset was purchased, and that purchase appears in investing activities. Adding depreciation back removes a non-cash expense from operating cash flow.

How often should I prepare a cash flow statement?

Monthly is useful for companies watching runway or managing tight working capital, and quarterly works for most others. An annual statement is the minimum if your company produces full financial statements for lenders, investors, or an audit.