The cash flow statement explains why cash changed during the period. It has three sections.
CFO + CFI + CFF = change in cash.
Nearly all companies start with net income and adjust it to cash:
Maple Outfitters, with receivables up 20, inventory up 30 and payables up 10:
| Line | Amount |
|---|---|
| Net income | 82.5 |
| Add: depreciation and amortization | 50.0 |
| Less: increase in receivables | (20.0) |
| Less: increase in inventory | (30.0) |
| Add: increase in payables | 10.0 |
| Cash flow from operations | 92.5 |
| Capital expenditures | (70.0) |
| Cash flow from investing | (70.0) |
| Debt repaid | (10.0) |
| Dividends paid | (20.0) |
| Cash flow from financing | (30.0) |
| Net change in cash | (7.5) |
Maple earned 82.5 of profit and 92.5 of operating cash, yet its cash balance fell by 7.5 because it reinvested and paid shareholders and lenders.
FCF = CFO minus capital expenditures = 92.5 minus 70 = 22.5. This is the cash left for debt repayment, dividends, buybacks and acquisitions. Maple paid 30 to lenders and shareholders from 22.5 of free cash flow, so it drew down cash.
Cash conversion = CFO / net income = 92.5 / 82.5 = 1.12. A ratio persistently below 1 means profits are not turning into cash.
Instead of starting from net income, the direct method lists actual cash receipts and payments: cash from customers, cash to suppliers and employees, interest and taxes paid. IFRS encourages it, but few companies use it. You can rebuild it from the income statement and balance sheet changes.
Using the Module 5 figures (receivables up 20, inventory up 30, payables up 10):
| Line | Calculation | Amount |
|---|---|---|
| Cash from customers | Revenue 1,000 minus increase in receivables 20 | 980.0 |
| Cash to suppliers | COGS 600 + increase in inventory 30 minus increase in payables 10 | (620.0) |
| Cash SG&A | Assumed paid as incurred | (220.0) |
| Interest paid | (20.0) | |
| Tax paid | (27.5) | |
| Cash flow from operations | 92.5 |
The answer matches the indirect method, as it must. The direct layout shows where the cash actually went.
A company sells equipment with a book value of 30 for 40, a gain of 10. The gain is in net income, so the indirect method subtracts 10 from operating cash flow, and the full proceeds of 40 appear in investing cash flow. Without the adjustment, the 10 would be counted twice.
Buying an asset with new shares, taking on a lease, or converting debt to equity uses no cash, so none of these appear in the cash flow statement. They are disclosed separately. A company that acquires businesses mainly with shares can show low capital spending and still be investing heavily.
Some capex simply replaces worn assets; the rest expands the business. Companies rarely split the two. Depreciation is a rough proxy for maintenance capex in a stable business. Free cash flow after only maintenance capex shows what the existing business could pay out if it stopped growing.
| Measure | Formula | Use |
|---|---|---|
| Free cash flow (simple) | CFO minus capex | Quick screen |
| Free cash flow to the firm | EBIT x (1 minus tax rate) + D&A minus capex minus increase in working capital | Valuing the whole business (RS 301) |
| Free cash flow to equity | CFO minus capex + net borrowing | Valuing the shares directly |
| FCF after leases and SBC | CFO minus capex minus lease principal minus stock-based compensation | Comparing IFRS and US GAAP firms honestly |
Operating cash flow can be lifted temporarily by stretching payables at quarter end, selling receivables to a factor, cutting inventory before the reporting date, or classifying cash flows aggressively (for example, interest received or paid placed outside operations under IFRS). Look at payables days and receivables sales in the notes before praising a jump in CFO.
Under US GAAP, interest paid and interest and dividends received are operating cash flows. Under IFRS, companies may classify interest paid as operating or financing and interest received as operating or investing. Check the classification before comparing CFO across companies. Under IFRS 16, the principal part of lease payments sits in financing, which lifts CFO compared with a US GAAP operating lease.
For one company, copy three years of net income, CFO, capex and FCF. Compute cash conversion each year and identify the largest adjustment between net income and CFO.
Educational content only; not investment, tax or legal advice. Companies, tickers and figures are illustrative examples, not recommendations. Rules, rates and limits change, so check current details with the regulator, exchange or tax authority before relying on them. Worked examples are not forecasts. Written by Elizabeta Dimoska. RiskStock is not a registered dealer or adviser.