Ch4. The Cash Flow Statement — Why Profit and Cash Are Not the Same Thing

Why Profitable Companies Still Go Bankrupt

Profitable Insolvency: A situation where a company’s income statement shows a profit, but a shortage of actual cash leads to bankruptcy.

→ Under accrual accounting, profit is recorded even when actual cash has not yet been received.

Example: A company with high credit sales
→ Income Statement: Revenue recorded
→ Cash Flow Statement: No cash inflow
→ Unable to pay employee salaries and supplier invoices → insolvency

The Three Sections of the Cash Flow Statement

Cash Flow Statement = Operating Activities + Investing Activities + Financing Activities

Cash Flow from Operating Activities (CFO)

Cash flows generated from the company’s core business (selling products and services).

Inflows: Customer payments received, interest income received Outflows: Raw material purchases, payroll, interest paid, income taxes paid

Healthy company: CFO > 0 (generating cash from operations)

Cash Flow from Investing Activities (CFI)

Cash flows from the acquisition and disposal of long-term assets.

Inflows: Sale of PP&E, proceeds from investment disposals Outflows: Capital expenditures (equipment, facilities), acquisitions, long-term investments

Growth company: CFI < 0 (aggressive investment)

Cash Flow from Financing Activities (CFF)

Cash flows from raising capital (borrowing, equity issuance) and returning it (debt repayment, dividends).

Inflows: New borrowings, proceeds from stock issuance Outflows: Debt repayment, dividends paid, share buybacks

Direct Method vs. Indirect Method

Two methods for presenting cash flow from operating activities:

Category	Direct Method	Indirect Method
Approach	Shows actual cash receipts and payments	Starts with net income and adjusts
Information provided	More detailed cash flow picture	Clearly shows difference between income and cash
International standards	Preferred by IFRS	Most commonly used in practice

Indirect Method Adjustments:

Net Income
+ Non-cash expenses (depreciation, amortization)
- Non-cash income (gain on asset disposal)
- Increases in working capital (accounts receivable ↑, inventory ↑)
+ Decreases in working capital (accounts payable ↑)
= Cash Flow from Operating Activities (CFO)

Free Cash Flow (FCF)

Free Cash Flow = Cash Flow from Operating Activities − Capital Expenditures (CAPEX)

The cash a company has left over after making the investments necessary to maintain and grow the business.

FCF > 0: Can pay dividends, buy back shares, repay debt, or invest further
FCF < 0: Requires external financing

Why investors care: FCF is harder to manipulate than net income and better reflects a company’s true value-creation capacity.

Reading Company Health from Cash Flow Patterns

CFO	CFI	CFF	Interpretation
+	−	−	High-quality mature company (investing + repaying debt)
+	−	+	Growth company (raising capital to fund investment)
−	−	+	Company in distress (covering operating losses)
+	+	−	Restructuring company (selling assets)

Profitable Insolvency ★★★★★ : Going bankrupt despite being profitable because of insufficient cash. Demonstrates that profit and cash flow can diverge under accrual accounting. Memory tip: Profit ≠ Cash → the reason we need a cash flow statement

Cash Flow from Operating Activities (CFO) ★★★★★ : Net cash inflow from the core business. The key indicator of sustainable earnings. A healthy company must have CFO > 0. Memory tip: CFO = operating cash generation power

Free Cash Flow (FCF) ★★★★☆ : Operating CF − Capital Expenditures. The cash a company is free to use however it chooses. A core metric in business valuation. Memory tip: FCF = CFO − CAPEX

Practice Quiz

Q. Under the indirect method, why is depreciation added back when calculating operating cash flow?

Depreciation is deducted as an expense on the income statement, reducing net income — but no actual cash leaves the company. To calculate cash flow, it must be added back as a non-cash charge.

Q. A company has positive CFO, negative CFI, and negative CFF. What type of company is this?

The classic pattern of a high-quality mature company. It generates cash from operations, invests in capital expenditures, repays debt, and pays dividends — a healthy financial structure.