The profit and loss statement tells you whether the business made money. The balance sheet tells you what it owns and owes. But the statement of cash flows — often overlooked or generated as an afterthought — tells you something neither of those statements can: where the cash actually went. A business that is profitable on paper but has negative operating cash flow is sending a distress signal. Understanding how to prepare and interpret the cash flow statement is a genuinely useful skill for bookkeepers advising small and medium businesses.
Why the Statement of Cash Flows Matters
Profit is an accounting construct. It includes non-cash items (depreciation, accruals, provisions) and ignores the timing of cash receipts and payments. A business that sells on 60-day terms and pays suppliers on 30-day terms may show strong profit while constantly struggling for cash. Conversely, a business that receives deposits before delivering services may have strong cash flow but modest profit.
The statement of cash flows reconciles net profit to actual cash movement, and categorises that movement into three sections: operating, investing, and financing. Reading the three sections together tells you whether the business generates cash from its core operations, how it deploys capital, and how it funds itself.
The Two Preparation Methods
There are two approaches to preparing the statement:
Direct method: Record each category of cash receipt and payment directly — cash received from customers, cash paid to suppliers, cash paid to employees, interest paid, taxes paid. This produces the clearest picture but requires tracking cash movements at a category level that many accounting systems don't provide automatically.
Indirect method: Start with net profit (or net loss) and work backwards, adjusting for non-cash items and changes in working capital to arrive at net cash from operations. This is the more common method because the inputs (profit, depreciation, and balance sheet movements) are readily available from the financial statements.
AASB 107 (Statement of Cash Flows) technically prefers the direct method for disclosure but permits the indirect method, which is why most accounting software generates an indirect-method statement.
Preparing the Operating Section (Indirect Method)
Start with net profit before tax. Then make the following adjustments:
Add back non-cash charges:
- Depreciation and amortisation (deducted in calculating profit but no cash left the business)
- Impairment losses (same logic)
- Provision movements (bad debt provisions, warranty provisions) if not yet settled in cash
Adjust for changes in working capital:
- Increase in trade receivables → subtract (cash not yet collected)
- Decrease in trade receivables → add (more cash collected than revenue earned)
- Increase in inventory → subtract (cash spent to build up stock)
- Decrease in inventory → add (stock converted to cash)
- Increase in trade payables → add (supplier payments deferred — cash retained)
- Decrease in trade payables → subtract (paying down payables)
- Increase in accrued expenses → add
- Decrease in accrued expenses → subtract
The result is net cash from operating activities. A healthy operating business should consistently produce positive operating cash flow. If operating cash flow is negative while net profit is positive, the working capital movements are absorbing cash — often a sign of rapid growth (receivables and inventory expanding) or deteriorating supplier terms.
The Investing Section
The investing section captures capital expenditure and proceeds from asset disposals. It shows how the business is deploying cash into (or receiving cash from) long-term assets:
- Purchase of plant, equipment, or property → outflow
- Proceeds from asset disposals → inflow
- Purchase of investments (shares, managed funds) → outflow
- Proceeds from investment disposals → inflow
- Loans made to related parties → outflow
- Repayments of loans from related parties → inflow
High investing outflows typically indicate a business that is growing or replacing aging equipment — which is often positive. Consistent net investing outflows without corresponding operating cash generation is a warning sign.
The Financing Section
The financing section covers how the business raises and repays capital:
- Proceeds from new borrowings → inflow
- Repayment of loans → outflow
- Proceeds from new equity (shares issued, capital contributions) → inflow
- Dividends or drawings paid to owners → outflow
For many small businesses, the financing section is dominated by owner drawings, loan repayments on equipment finance, and any new borrowings taken during the year.
Reconciliation and Checking Your Work
The statement should reconcile: the opening cash balance plus net movement (operating + investing + financing) should equal the closing cash balance as shown on the balance sheet. If it doesn't, there's an error in one of the three sections or a movement that hasn't been classified.
Common errors to look for:
- GST paid to the ATO classified as a tax payment rather than operating (it should be in operating, as a reduction in cash from operations)
- Loan repayments split incorrectly between principal (financing) and interest (operating)
- Asset disposals where proceeds appear in the bank but no investing inflow has been recorded
- Opening and closing balance sheet figures used inconsistently (using the wrong comparison period)
Using the Statement to Advise Clients
The most useful question the cash flow statement answers for a small business client is: "Is my business self-funding its operations, or am I relying on debt or my own equity to keep it running?" A business with strong operating cash flow can fund its own growth and service its debt. A business with weak operating cash flow but strong profit needs to understand where its profit is going — usually into receivables or inventory that haven't been converted to cash.
Most accounting software (Xero, MYOB, QuickBooks) generates a cash flow statement automatically in indirect method format. The bookkeeper's job is to ensure the underlying data is clean — particularly the classification of loan movements, owner transactions, and asset disposals — so the generated statement is reliable enough to actually use.