When I first started advising small businesses many years ago, I noticed that most owners had a decent grasp of profit and loss statements but often gave blank stares when asked about their cash flow statements. Yet, in my experience, understanding cash flow is often what separates thriving businesses from those that struggle despite showing a profit on paper. The phrase “profitable but broke” exists for a reason.
Cash flow statements aren’t just accounting documents—they’re stories about how money moves through your business. And being able to read this story clearly can make all the difference in how you make decisions.
Let me walk you through what cash flow statements are, why they matter so much, and how you can use them to better understand the financial health of your business.
What Is a Cash Flow Statement?
A cash flow statement is a financial document that shows how cash and cash equivalents move in and out of your business during a specific period. While that sounds straightforward, there’s an important distinction to understand: cash flow statements track actual money changing hands, not promises to pay or be paid.
This is what makes cash flow statements different from other financial reports. They don’t care about when you sent an invoice or when you received a bill—they only care about when money actually moved.
Think of it this way: if your business were a bathtub, your income statement would tell you how much water should be coming in from the faucet and draining out. Your balance sheet would show how much water is in the tub at a specific moment. But your cash flow statement would tell you exactly how much water actually flowed in and out during a certain timeframe, regardless of what was supposed to happen.
The Three Main Components of a Cash Flow Statement
Cash flow statements are typically divided into three sections, each representing a different type of activity:
1. Cash Flow from Operating Activities
This section shows the cash generated by your core business operations—the things you actually do as a business. For a retail store, this would include cash from selling products minus cash spent on inventory, wages, rent, and other operational expenses.
Operating cash flow is often considered the most important section because it shows whether your primary business activities are generating or consuming cash. A consistently negative operating cash flow means your core business isn’t sustainable without external funding.
Examples of operating cash flows include:
- Cash received from customers
- Cash paid to suppliers and employees
- Interest paid
- Income taxes paid
2. Cash Flow from Investing Activities
This section captures cash used for long-term asset investments or generated from selling those assets. These aren’t day-to-day expenses but rather investments in the future productive capacity of your business.
Examples include:
- Purchasing or selling equipment
- Buying or selling property
- Acquiring another business
- Investing in securities
Negative cash flow from investing activities isn’t necessarily bad—it often means you’re expanding and investing in growth. However, these investments should eventually lead to increased operating cash flow.
3. Cash Flow from Financing Activities
This section shows cash flows related to funding your business through debt or equity and returning money to lenders or owners.
Examples include:
- Taking out or repaying loans
- Issuing or buying back shares (if incorporated)
- Paying dividends to shareholders
- Owner contributions or withdrawals
When you add these three sections together, you get your net cash flow—the actual increase or decrease in your cash position over the period.
The Purpose of a Cash Flow Statement
Cash flow statements serve several critical purposes for businesses of all sizes:
1. Measuring Liquidity
The primary purpose is to assess whether your business is generating enough cash to meet short-term obligations. You might show a profit on paper, but if that profit is tied up in inventory or accounts receivable, you could still fail to pay your bills on time.
2. Evaluating Financial Health
Cash flow statements reveal patterns about your business that other statements can’t. For example:
- Are you consistently generating positive operating cash flow, or are you relying on financing to keep afloat?
- Are your investing activities in line with your strategic goals?
- Is your business self-sustaining, or does it require constant cash infusions?
3. Planning for the Future
Cash flow statements provide data for forecasting. By understanding your historical cash flow patterns, you can better predict future cash needs and avoid surprises.
4. Informing Strategic Decisions
Should you expand? Can you afford new equipment? Is it time to seek investors? Cash flow information is crucial for making these decisions wisely.
5. Attracting Investment and Loans
Lenders and investors scrutinize cash flow statements to assess risk. Strong, consistent operating cash flow makes your business more attractive.
How Cash Flow Statements Are Prepared
There are two methods for preparing the operating section of a cash flow statement: direct and indirect. The other sections (investing and financing) are prepared the same way regardless of which method you use.
The Direct Method
The direct method lists all actual cash receipts and payments during the period. For example:
- Cash received from customers: $100,000
- Cash paid to suppliers: $40,000
- Cash paid to employees: $30,000
- Cash paid for rent: $10,000
- Cash paid for utilities: $5,000
- Net operating cash flow: $15,000
This method is straightforward but requires detailed tracking of all cash transactions, which many businesses find cumbersome.
The Indirect Method
The indirect method (more commonly used) starts with net income from the income statement and adjusts it to convert from accrual to cash basis. The adjustments include:
- Adding back non-cash expenses (like depreciation)
- Adjusting for changes in working capital (inventory, accounts receivable, accounts payable)
- Removing gains or losses from investing or financing activities
For example:
- Net income: $20,000
- Add back depreciation: $5,000
- Subtract increase in accounts receivable: ($8,000)
- Add increase in accounts payable: $3,000
- Subtract gain on sale of equipment: ($5,000)
- Net operating cash flow: $15,000
Both methods arrive at the same net operating cash flow number, but they take different paths to get there.
Cash Flow Statements vs. Other Financial Statements
To truly understand cash flow statements, it helps to see how they compare with other key financial reports.
Cash Flow Statement vs. Income Statement
Income Statement (Profit & Loss)
- Shows revenue and expenses when earned or incurred (accrual basis)
- Includes non-cash items like depreciation
- Answers: “Is the business profitable?”
Cash Flow Statement
- Shows actual cash movements
- Excludes non-cash accounting entries
- Answers: “Can the business pay its bills?”
A business can be profitable according to the income statement but still have negative cash flow if, for example, customers haven’t paid their invoices or the business has invested heavily in inventory or equipment.
Cash Flow Statement vs. Balance Sheet
Balance Sheet
- Shows assets, liabilities, and equity at a specific point in time
- Provides a snapshot of financial position
- Answers: “What does the business own and owe right now?”
Cash Flow Statement
- Shows movement of cash over a period
- Provides a dynamic view of cash changes
- Answers: “Where did our money come from and go to over this period?”
The balance sheet tells you how much cash you have at the beginning and end of a period, while the cash flow statement explains what happened to cause any change.
A Real-World Example for Small Business Owners
Let’s consider a hypothetical small retail business, “Main Street Boutique,” and see what its cash flow statement might look like:
What story does this tell us?
- The business is profitable and generating positive operating cash flow ($60,000)
- However, they’ve invested heavily in equipment and shop improvements ($65,000)
- To support this growth, they’ve taken out a bank loan ($50,000)
- The owner has also withdrawn $30,000 from the business
- Despite the heavy investment, cash has increased by $15,000 over the year
This paints a picture of a growing, profitable business that’s investing in its future. The loan seems justified given the investments made and the positive operating cash flow. However, if this pattern continued year after year (constantly needing financing to cover negative overall cash flow), it might indicate a problem.
Why Cash Flow Matters More Than Profit for Small Businesses
I’ve seen many small businesses fail despite being “profitable” on paper. Why? Because they ran out of cash. Here’s why cash flow often matters more than profit for small businesses:
- Timing Differences: Profit doesn’t account for timing. You might make a sale in January but not get paid until March. Meanwhile, you still need to pay your employees in February.
- Growth Consumes Cash: Ironically, rapid growth can kill businesses through what I call “success bankruptcy.” As you grow, you need more inventory, more staff, and more space—all before you’ve collected from your expanding customer base.
- Capital Expenditures: Your income statement spreads the cost of major purchases over time through depreciation, but your bank account takes the hit all at once.
- Debt Repayment: Principal payments on loans don’t appear on your income statement, but they definitely impact your cash balance.
- Owner Compensation: Many small business owners take irregular draws instead of steady salaries, creating cash flow volatility.
How to Use Your Cash Flow Statement Effectively
Now that you understand what cash flow statements are, here’s how to use them to improve your business:
1. Track Trends Over Time
Look at your cash flow statements over several periods. Are operating cash flows increasing? Is your reliance on debt growing or shrinking? Patterns often reveal more than any single statement.
2. Calculate Cash Flow Ratios
- Operating Cash Flow Ratio = Operating Cash Flow ÷ Current Liabilities This shows your ability to cover short-term obligations from operations.
- Cash Flow to Debt Ratio = Operating Cash Flow ÷ Total Debt This indicates how quickly you could pay off all debt if you devoted all operating cash flow to it.
3. Create Cash Flow Forecasts
Use historical cash flow data to create forward-looking projections. This helps identify potential cash crunches before they occur.
4. Make More Informed Decisions
Before making major investments or taking on new debt, run the scenarios through your cash flow forecast. Can you afford it? What will the impact be six months from now?
5. Set Cash Flow Targets
Just as you might set profit goals, set cash flow targets. For example: “We want our operating cash flow to exceed our investing cash outflows by the end of next year.”
Conclusion
Cash flow statements might not be as immediately satisfying as seeing profits on an income statement, but they tell a deeper truth about your business. They reveal whether your business model actually works in practice, not just in theory.
For small business owners, I’d argue that understanding and managing cash flow is the single most important financial skill you can develop. It’s not just about survival—though that’s certainly important—it’s about creating a business that can weather storms, seize opportunities, and provide stability for you and your employees.
Remember: Profits are an opinion, but cash is a fact. Your cash flow statement is where those facts live. Learn to read it well, and you’ll have a powerful tool for building a more resilient business.
What aspects of your cash flow statement have you found most challenging to understand or manage? I’d love to hear about your experiences in the comments below.