Cash Flow Statement: The Three Sections, Methods and How to Read It

The cash flow statement shows how much cash a company received and paid during a period, and why its cash balance changed between the start and the end of that period. It sorts every cash movement into three groups: operating activities, investing activities and financing activities. Read together with the income statement and the statement of financial position, it tells you whether reported profit is turning into cash, how the business pays for its investments and how much it depends on lenders and shareholders.

What the cash flow statement shows

Profit and cash are not the same thing. The income statement is prepared on the accrual basis: a sale counts as revenue when it is earned, even if the customer has not paid yet, and an expense counts when it is incurred, even if the bill is still open. The cash flow statement removes this timing effect and reports only the actual movements of cash and cash equivalents.

Cash equivalents are short-term, highly liquid investments that can be turned into a known amount of cash with little risk of a change in value. Bank overdrafts that are repayable on demand and form part of day-to-day cash management may be deducted from them. The statement starts with the opening balance of cash and cash equivalents, adds the net movement from the three sections, adjusts for the effect of exchange rate changes on cash held in foreign currency, and arrives at the closing balance.

The three sections

Operating activities

These are the cash flows from the main revenue-producing activities of the business: receipts from customers, payments to suppliers and employees and for running expenses, and usually income tax and Zakat paid. For most companies this is the most important section, because it shows whether the core business generates cash on its own.

Investing activities

These are payments to acquire long-term assets and investments, and receipts from selling them: property, plant and equipment, intangible assets, shares in other companies and loans made to others. Only spending that results in an asset recognized on the statement of financial position belongs here.

Financing activities

These are the cash flows with owners and lenders: proceeds from issuing shares or capital contributions, new borrowing and loan repayments, the principal part of lease payments, and dividends paid to shareholders where the company chooses to show them here.

The current standard allows some choices for interest and dividends. Interest paid may be shown in operating or financing activities, and interest and dividends received in operating or investing activities, as long as the company applies its choice consistently. The international standards have been amended in a way that narrows these choices for most companies in coming reporting periods, so confirm with your auditor which version applies to your financial year.

The direct and indirect methods

The operating section can be presented in two ways. The investing and financing sections look the same under both.

The direct method lists the main classes of gross cash receipts and payments: cash received from customers, cash paid to suppliers, cash paid to employees and so on. It is easy for a non-accountant to read, and the international standard encourages it, but it needs records that capture cash by type.

The indirect method starts from profit or loss and adjusts it in three steps:

1. Add back non-cash expenses such as depreciation, amortization, impairment and provisions, including the end-of-service benefits provision, and remove non-cash income.
2. Remove gains and losses whose cash belongs in another section, such as a gain on selling equipment, because the sale proceeds are part of investing activities.
3. Adjust for changes in working capital: an increase in receivables or inventory reduces cash, an increase in payables increases it, and the reverse applies when these balances fall.

Most companies use the indirect method because it can be prepared from the income statement and the opening and closing statements of financial position. Whichever method you use, the net cash from operating activities is the same.

How it links to the other financial statements

• The income statement provides the starting profit under the indirect method, as well as the depreciation, provisions and gains that are adjusted.
• The statement of financial position provides the opening and closing cash, and the movements in receivables, inventory, payables, fixed assets, loans and equity that explain the rest of the statement.
• The statement of changes in equity shows capital increases and dividends declared, which link to cash received from owners and dividends paid.

A useful test: the closing cash in the cash flow statement must equal the cash and cash equivalents on the statement of financial position, or be reconciled to it in a note. If not, something is missing.

Which standards apply in Saudi Arabia

Companies in Saudi Arabia prepare their financial statements under International Financial Reporting Standards as endorsed by the Saudi Organization for Chartered and Professional Accountants (SOCPA). The standard that governs this statement is IAS 7, Statement of Cash Flows. Listed companies apply full IFRS as endorsed by SOCPA, and many smaller unlisted companies apply the IFRS for SMEs as endorsed in the Kingdom, which also requires a statement of cash flows. SOCPA publishes the endorsed standards and any additional disclosure requirements on its website.

How to prepare it step by step

1. Collect the income statement for the period and the statements of financial position at its start and end.
2. Define what counts as cash and cash equivalents, and agree the opening and closing balances to the bank statements.
3. Start from profit for the period and add back the non-cash items.
4. Calculate the change in each working capital line, leaving out balances that relate to investing or financing, such as an amount still owed to an equipment supplier.
5. Analyze the movement in fixed assets and investments to find the cash actually paid and received, separating purchases made on credit.
6. Analyze loans, lease liabilities, capital and dividends to build the financing section.
7. Show the effect of exchange rate changes on foreign currency cash as a separate line.
8. Check that opening cash plus the net movement equals closing cash, then prepare the notes on non-cash transactions and on changes in liabilities arising from financing activities.

If your accounting system does not produce the statement automatically, an accountant can build it from the trial balance. Innovant’s accounting team helps companies in Saudi Arabia prepare their financial statements, including this one.

What a reader looks for

• Operating cash compared with profit. A company that reports profits period after period but little operating cash may be selling on long credit terms, building up stock or recognizing revenue too early.
• Free cash flow. Operating cash minus spending on fixed assets shows what is left to repay debt or pay dividends.
• How growth is funded. Large investments paid for with new loans carry more risk than investments funded from operations.
• Working capital trends. Receivables or inventory growing faster than sales often signal collection or stock problems before they show up in profit.
• One-off items. Proceeds from selling assets can make a weak year look strong, so banks and investors look at them separately.

Common preparation mistakes

• Putting non-cash transactions in the statement, such as equipment bought on credit, a new lease or a loan converted into capital. These are excluded and disclosed in the notes.
• Getting the sign wrong on working capital movements.
• Counting a gain on sale twice, once in profit and again in investing proceeds, without removing it from the operating section.
• Netting receipts and payments that should be shown gross, such as new borrowing and loan repayments.
• Treating restricted or pledged deposits as cash without explanation.
• Treating the end-of-service provision as cash: the charge for the period is added back, and only the benefits actually paid to departing employees are cash outflows.
• Ignoring the effect of exchange rates on cash held in foreign currency.
• Changing the classification of interest or dividends from one period to the next without explanation.

Frequently asked questions

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