How to Read a Cash Flow Statement
Why profit tells you what a company earned—and cash flow tells you whether it's real
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This is part three of my How to Understand Financial Statements series. A series for business owners and investors to finally get their heads around the three financial statements to improve their financial intelligence. Part one taught you How to Read an Income Statement and part two revealed Why Warren Buffett Reads the Balance Sheet Before Anything Else. Today’s piece is the third leg of the tripod: How to Read a Cash Flow Statement.
For decades Wall Street adored the income statement with measures such as EBITDA (famed by the cable cowboy John Malone) their preferred metric for determining how well a company was doing. EBITDA going up was good. EBITDA going down was bad.
But, if you’ve been following this series you should know by now that profit isn’t cash. You can’t pay for new equipment with profit, can’t pay your staff with profit—and you can’t pay your liabilities with profit either. You can only pay for things with cash.
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If the income statement is a company’s report card, and the balance sheet is its photograph, then the cash flow statement is its bank statement.
It tells you one thing: where did the money actually go?
Why profit and cash are not the same thing
This is the part that trips most people up, so let’s deal with it first.
Two obvious reasons are that cash may be coming in by other means such as loans or from external investment. These won’t show up on the income statement, but will show up on the cash flow statement. But, there are also three not so obvious reasons for those who don’t yet fully understand the three financial statements:
Revenue is booked at sale. When a company makes a sale or delivers a service, it records that sale as revenue. For example, my construction company takes on a months long timber window repair scheme for £15,000. We finish the job and invoice at the end of the month, but the customer (in construction) has 30 days to pay. No money will go into my bank account until that 30 days, but we record the project cost of £15,000 under revenue on our income statement. The profit is real; the cash is not yet there.
Expenses are matched to revenue. The income statements main function is to tally up all costs and expenses associated with generating revenue during a given time period. Some expenses will have been prepaid already (a deposit on office rental), but most will be paid later. In my construction example, i have to pay merchants for materials, typically on account, and the subcontractors who carried out the work. If we’re doing our job right, both will typically be paid by us after we’ve been paid by the client.
Capital expenditures don’t count against profit. I spend £60,000 on a new Ford Ranger, but that 60k doesn’t show up on the income statement as 60k. Remember...it shows up as depreciation. My accountant uses a straight-line method to depreciate the truck over three years. That’s £20,000 a year, or £1,666.66 a month of depreciation for 36 months—but the day i bought the truck i parted ways with £60,000 from my bank account.
In an ideal world cash should track net profit pretty closely, but for start-ups, or those businesses that are struggling—the discrepancy between profit and cash can be fatal.
Let’s continue to use Visa‘s financial statements as our walkthrough example for completeness.
