Lesson 15 of 33 · Free
Contents
- 1 Statement of Cash Flows
- 1.1 Why a third statement?
- 1.2 The three sections
- 1.3 Direct vs. indirect method
- 1.4 Indirect method, step by step
- 1.5 A full example
- 1.6 Quality of earnings: CFO vs. Net Income
- 1.7 Practice
- 1.8 Lesson recap
- 1.9 Practical Indian Application
- 1.10 Worked Example (in Rupees)
- 1.11 Frequently Asked Questions
- 1.12 Free Cash Flow & Quality Metrics
Statement of Cash Flows
Why a profitable business can still go bankrupt. Master operating, investing, and financing cash flows.
Why a third statement?
The income statement says you made money. The balance sheet says you’re solvent. But neither tells you whether you can actually pay next month’s rent. That’s what the cash flow statement answers — where cash came from and where it went over a period.
A profitable business can run out of cash. A loss-making one can be cash-rich. The cash flow statement bridges the gap between accrual-basis profit and bank-account reality.
The three sections
1. Cash from Operating Activities (CFO)
Cash generated or used by the core business. The most important section — long-term, a healthy business should generate positive CFO.
- + Cash received from customers
- − Cash paid to suppliers
- − Cash paid to employees
- − Cash paid in interest (under most frameworks)
- − Cash paid in income tax
2. Cash from Investing Activities (CFI)
Long-term asset moves. Most growing businesses have negative CFI because they’re buying equipment, machinery, software.
- − Purchase of property, plant & equipment (CapEx)
- + Sale of equipment or investments
- − Acquisitions of other businesses
- +/− Loans given to / repaid by others
3. Cash from Financing Activities (CFF)
How the business is financed — from owners (equity) and lenders (debt).
- + Issue of share capital
- + Loans taken
- − Loan repayments
- − Dividend payments
- − Share buybacks
Direct vs. indirect method
Direct method: lists actual cash receipts and payments line by line (“Cash collected from customers ₹8,00,000; Cash paid to suppliers ₹3,00,000…”). Intuitive but requires more detail.
Indirect method: starts from net income and adjusts for non-cash items and working-capital changes to arrive at CFO. Used by ~98% of companies because it ties cleanly to the income statement and balance sheet. We’ll focus on this one.
Indirect method, step by step
Start with net income from the income statement. Then:
- Add back non-cash expenses — depreciation, amortisation, stock-based compensation. These hit profit but never moved cash.
- Adjust for working-capital changes:
- AR increased → customers paid you less than you billed → subtract.
- AR decreased → you collected more than you billed → add.
- Inventory increased → you bought more than you sold → subtract.
- AP increased → you paid suppliers less than you bought → add (less cash out is good for you).
- Subtract gains and add back losses on asset sales — those belong in CFI, not CFO.
A full example
Café Latte Pvt. Ltd. — Cash Flow Statement for FY2026:
| Line | ₹ |
|---|---|
| OPERATING | |
| Net income | 22,500 |
| + Depreciation | 5,000 |
| − Increase in AR | (3,000) |
| − Increase in inventory | (2,000) |
| + Increase in AP | 4,500 |
| + Increase in accrued expenses | 1,500 |
| CFO | 28,500 |
| INVESTING | |
| − Purchase of equipment | (15,000) |
| CFI | (15,000) |
| FINANCING | |
| + New loan | 10,000 |
| − Dividend | (5,000) |
| CFF | 5,000 |
| Net change in cash | 18,500 |
| + Opening cash | 34,000 |
| Closing cash | 52,500 |
The closing cash matches the cash line on the balance sheet. ✓
Quality of earnings: CFO vs. Net Income
Compare CFO to net income year over year. If net income keeps growing but CFO stays flat or declines, the company may be:
- Booking sales it isn’t collecting (AR ballooning).
- Building inventory it can’t sell.
- Stretching payables to delay cash outflow.
This ratio — CFO ÷ Net Income — is one of the first things experienced investors look at. Healthy businesses keep it above 1 over a multi-year window.
Practice
Net income ₹10,00,000; depreciation ₹2,00,000; AR decreased by ₹50,000; inventory increased by ₹1,00,000; AP decreased by ₹30,000.
Answer: CFO = 10,00,000 + 2,00,000 + 50,000 − 1,00,000 − 30,000 = ₹11,20,000.
Lesson recap
- Cash flow statement = where cash came from and where it went.
- Three sections: Operating (core), Investing (long-term assets), Financing (debt & equity).
- Indirect method: start from net income, add back non-cash items, adjust working capital.
- Profit ≠ cash. Always check CFO before celebrating net income.
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Practical Indian Application
The Cash Flow Statement explains how cash and cash equivalents moved during a period, segregated into three activities: Operating (cash from core business), Investing (capex, asset sales, acquisitions) and Financing (debt, equity, dividends). Indian companies prepare it under Ind AS 7 or AS 3. The ‘Indirect Method’ starts with Profit Before Tax, adjusts for non-cash items (depreciation, finance costs), working-capital changes (debtors, creditors, inventories) and taxes paid, to arrive at cash from operations. Investing and financing flows are listed explicitly. A reader cross-checks the statement by ensuring that Opening Cash + Net Change = Closing Cash on the balance sheet. The cash flow statement reveals whether reported profit is being converted into actual cash — the single most important quality metric an analyst tracks.
Worked Example (in Rupees)
Marico (illustrative) reports FY26: PBT ₹1,800 crore + Depreciation ₹150 crore + Finance Costs ₹40 crore − Working Capital Increase ₹220 crore − Taxes Paid ₹450 crore = Cash from Operations ₹1,320 crore. Investing: Capex (₹250 crore) − Acquisition (₹150 crore) + Interest Received ₹80 crore = (₹320 crore). Financing: Debt Repayment (₹200 crore) − Dividends Paid (₹600 crore) − Interest Paid (₹40 crore) = (₹840 crore). Net Change in Cash = 1,320 − 320 − 840 = ₹160 crore. Opening cash ₹450 crore + ₹160 = Closing cash ₹610 crore. This shows Marico generated robust operating cash, invested moderately and returned a large portion to shareholders.
Frequently Asked Questions
Why is the Cash Flow Statement more important than the P&L?
Because reported profit can include non-cash items and accruals; cash flow tells the unvarnished truth about whether the business actually generates money.
What is the difference between Direct and Indirect methods?
Direct method lists actual receipts and payments; Indirect method starts from PBT and adjusts. Indian companies overwhelmingly use Indirect because of disclosure simplicity.
Where do bank overdrafts appear in the Cash Flow Statement?
Usually as part of ‘Cash and Cash Equivalents’ if integral to cash management; otherwise as financing activity (Ind AS 7 allows both approaches).
Is interest paid an Operating or Financing item?
Under Ind AS 7 it is a policy choice — most Indian firms classify interest paid under Financing and interest received under Investing.
Free Cash Flow & Quality Metrics
Free Cash Flow (FCF) = Cash from Operations − Capex. It represents the cash actually available to the firm after maintaining its capital base. A company with PAT of ₹1,000 crore but FCF of ₹200 crore is signalling either heavy reinvestment (positive growth interpretation) or working-capital deterioration (warning sign — investigate). Indian analysts compute FCF Yield (FCF / Market Cap) to compare across stocks — values above 5% suggest under-valuation.
Cash Quality Ratio = Operating Cash Flow / PAT. Above 1.0 is healthy; below 0.7 invites suspicion. Major Indian frauds (Satyam, IL&FS, Yes Bank, DHFL) all showed deteriorating cash quality ratios in the quarters leading to the fraud disclosure — a leading indicator that pure P&L analysis would have missed.
Try It: A company shows ₹600 cr PAT, ₹300 cr depreciation, ₹100 cr increase in receivables, ₹50 cr increase in payables, ₹400 cr capex. Cash Quality = (600 + 300 − 100 + 50)/600 = 1.42 (healthy). FCF = (600 + 300 − 100 + 50) − 400 = 450 cr. Apply this to any annual report and you will rapidly distinguish high-quality compounders from accounting illusions.