Cash Flow Statement Explained: Track Where Your Money Actually Goes

Your Profit and Loss statement shows profit. Your balance sheet shows net worth. But neither directly answers the question every business owner asks most often: Where did the cash go?

That’s what the cash flow statement answers.

If you’ve ever been profitable but broke, or wondered why your bank balance doesn’t match your profit, the cash flow statement explains the mystery.

Why Cash Flow Matters More Than Profit

Consider this scenario:

• Your P&L shows $50,000 profit for the year
• Your bank balance increased only $5,000
• Where did the other $45,000 go?

The answer is in the cash flow statement. Maybe you:

• Collected less from customers than you billed (receivables increased)
• Bought equipment
• Paid down debt principal
• Built up inventory

All of these use cash without appearing as expenses on the P&L.

The fundamental truth: You can’t pay bills with profit. You pay bills with cash. The cash flow statement shows what happened to your cash.

The Three Sections of Cash Flow

Every cash flow statement has three sections:

1. Operating Activities

Cash from your core business operations.

Cash In:

• Cash collected from customers
• Interest and dividends received
• Other operating receipts

Cash Out:

• Cash paid to suppliers and vendors
• Cash paid to employees
• Interest paid
• Taxes paid
• Other operating payments

Net Operating Cash Flow: The difference between operating cash in and cash out.

This is the most important section. It answers: Does your core business generate cash?

2. Investing Activities

Cash used for long-term assets and investments.

Cash In:

• Sales of equipment or property
• Sales of investments
• Proceeds from loans you made to others

Cash Out:

• Purchases of equipment or property
• Purchases of investments
• Loans made to others

Net Investing Cash Flow: Usually negative (businesses invest in assets), but not always.

3. Financing Activities

Cash from funding sources and returns to owners.

Cash In:

• Loans received
• Owner investments
• Stock issuances

Cash Out:

• Loan principal payments
• Owner draws/dividends
• Stock repurchases

Net Financing Cash Flow: Depends on whether you’re borrowing or repaying.

The Final Calculation

Net Change in Cash = Operating + Investing + Financing

This number explains why your bank balance changed.

Sample Cash Flow Statement

	Amount
CASH FLOWS FROM OPERATING ACTIVITIES
Net Income	$50,000
Adjustments:
Depreciation	$8,000
Increase in Accounts Receivable	($15,000)
Increase in Inventory	($10,000)
Increase in Accounts Payable	$4,000
Increase in Accrued Expenses	$2,000
Net Cash from Operating Activities	$39,000
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of Equipment	($25,000)
Net Cash from Investing Activities	($25,000)
CASH FLOWS FROM FINANCING ACTIVITIES
Loan Principal Payments	($6,000)
Owner Draws	($30,000)
Net Cash from Financing Activities	($36,000)
NET CHANGE IN CASH	($22,000)
Beginning Cash Balance	$67,000
Ending Cash Balance	$45,000

Reading This Statement

Operating Activities: $39,000 positive

• Started with $50,000 profit
• Added back $8,000 depreciation (non-cash expense)
• Subtracted $15,000 for higher receivables (billed but didn’t collect)
• Subtracted $10,000 for inventory increase (bought inventory)
• Added $4,000 for higher payables (owe more to vendors)
• Added $2,000 for accrued expenses (owe more, didn’t pay yet)

The core business generated $39,000 in actual cash.

Investing Activities: ($25,000)

• Bought $25,000 in equipment
• This is a use of cash

Financing Activities: ($36,000)

• Paid $6,000 on loan principal
• Owner took $30,000 in draws

Net Result: Cash decreased by $22,000

• Started with $67,000
• Ended with $45,000

Now we understand why cash dropped despite $50,000 profit.

What the Cash Flow Statement Reveals

1. Can Your Business Fund Itself?

Positive operating cash flow means your business generates the cash needed to operate. This is the goal.

Negative operating cash flow means you’re burning cash. You need outside funding (loans, investment, owner contributions) to stay alive.

2. How Cash Flow Differs from Profit

Common differences:

Item	P&L Treatment	Cash Impact
Depreciation	Expense (reduces profit)	No cash impact
Equipment purchase	Not an expense	Cash outflow
Loan principal payment	Not an expense	Cash outflow
Loan proceeds	Not income	Cash inflow
Billed but uncollected	Revenue (increases profit)	No cash yet
Inventory purchase	Not an expense until sold	Cash outflow

3. Where Cash Is Tied Up

If operating cash is lower than profit, cash is getting stuck somewhere:

• Receivables increasing: Cash stuck with customers
• Inventory increasing: Cash stuck in products
• Prepaid expenses increasing: Cash spent ahead of time

4. Investment in the Business

The investing section shows what you’re putting back:

• Are you reinvesting in equipment?
• Are you letting assets age without replacement?
• Are you making or selling investments?

5. Funding Strategy

The financing section reveals your capital structure:

• Are you taking on more debt or paying it down?
• How much is the owner taking out?
• Are you funding growth internally or externally?

Key Cash Flow Metrics

Operating Cash Flow Ratio

Operating Cash Flow ÷ Current Liabilities

Can you pay short-term obligations from operating cash?

• Above 1.0: Good, generating enough cash
• Below 1.0: May need other sources to pay bills

Cash Flow to Debt Ratio

Operating Cash Flow ÷ Total Debt

How quickly could you pay off all debt from operating cash?

• Higher is better
• Indicates financial flexibility

Free Cash Flow

Operating Cash Flow - Capital Expenditures

Cash available after maintaining/expanding the business.

• Positive: Money left for debt paydown, distributions, or savings
• Negative: Investing more than you’re generating

Cash Conversion Cycle

Days to convert inventory and receivables into cash:

• Receivables days: How long to collect
• Inventory days: How long inventory sits
• Payables days: How long you take to pay

Shorter cycle = faster cash conversion.

Common Cash Flow Patterns

Healthy Business

• Strong positive operating cash flow
• Moderate investing (maintaining/growing assets)
• Financing matches strategy (paying down debt or appropriate distributions)

Growth Phase

• Operating cash flow might lag (building receivables, inventory)
• Heavy investing (new equipment, facilities)
• Financing inflows (loans, investment) to fund growth

Troubled Business

• Negative operating cash flow
• Minimal investing (can’t afford it)
• Financing outflows (paying debt) or desperate inflows (more borrowing)

Mature Business

• Strong operating cash flow
• Minimal investing (maintenance only)
• Heavy distributions or debt paydown

Using Cash Flow for Decision Making

Before Major Purchases

Check your cash flow statement:

• Is operating cash sufficient to fund the purchase?
• Will the purchase improve future operating cash?
• Do you need financing?

Managing Receivables

If receivables are eating cash:

• Tighten credit policies
• Incentivize early payment
• Follow up faster on overdue accounts

Evaluating Profitability Quality

High profit with low operating cash may indicate:

• Aggressive revenue recognition
• Poor collections
• Overinvestment in inventory

Cash flow validates whether profit is real.

Planning Distributions

Before taking owner draws:

• Is operating cash positive?
• Have you covered necessary investments?
• Is there sufficient reserve remaining?

Don’t distribute more than operating cash supports.

Improving Cash Flow

Based on what the statement reveals:

Increase Operating Cash Flow

• Collect receivables faster
• Manage inventory tighter
• Negotiate longer payment terms with vendors
• Price for profit (higher margins = more cash per sale)

Reduce Investing Cash Outflow

• Lease instead of buy
• Buy used equipment
• Delay non-essential purchases
• Sell unused assets

Optimize Financing

• Refinance high-interest debt
• Match loan terms to asset life
• Balance distributions with business needs
• Build reserves before paying off low-interest debt

Monthly Cash Flow Review

Each month:

1. Review operating cash flow: Positive or negative? Why?
2. Check receivables impact: Did collection improve or worsen?
3. Note investing activity: What did you buy or sell?
4. Review financing changes: Debt taken or repaid? Distributions?
5. Compare to budget: Is cash trending as expected?

Forecasting Cash Flow

Use historical cash flow to project forward:

1. Estimate next month’s sales
2. Estimate collections based on typical timing
3. List known expenses and their timing
4. Add planned investments
5. Include debt payments and expected distributions

This becomes your cash flow forecast, warning you of potential shortfalls.

Cash Flow vs. P&L: When to Use Each

Use the P&L for:

• Evaluating profitability
• Pricing decisions
• Expense control
• Tax planning

Use the Cash Flow Statement for:

• Understanding cash position
• Planning major purchases
• Managing working capital
• Evaluating cash sustainability

Use together for:

• Complete financial picture
• Validating profit quality
• Understanding business health

Your Cash Flow Action Items

This Week

1. Pull your cash flow statement (or create one)
2. Identify your operating cash flow number
3. Compare to your net income

This Month

1. Analyze the adjustments in operating activities
2. Calculate free cash flow
3. Review investing and financing activities

Ongoing

1. Monitor monthly cash flow trends
2. Investigate significant changes
3. Use cash flow forecasting for planning

Next Steps

If your accounting software generates a cash flow statement, start reviewing it monthly. If it doesn’t, or if you’re not sure how to interpret it, that’s a gap worth filling.

Understanding your cash flow statement gives you insight that profit alone can’t provide. It explains why cash doesn’t match profit, where money is getting stuck, and whether your business is truly generating the cash it needs to thrive.

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Want help understanding your cash flow? At Profit Path Books, we help small business owners see where their cash is going—and how to keep more of it. Book a consultation to discuss your financial management needs.