The Cash Flow Statement: The King of the Financial Statements?

Cash Flow Statement Definition: In accounting, the Cash Flow Statement shows a company’s cash inflows and outflows over a specific period, such as 1 year, 1 quarter, or 1 month; items may be either *adjustments* to Income Statement line items or additional cash inflows or outflows that have *not* appeared on the Income Statement.

To understand the Cash Flow Statement, you must understand the Income Statement first, which we cover in a separate tutorial.

Put simply, the Income Statement shows a company’s revenue, expenses, and taxes over a period, but these do not necessarily represent real cash inflows and outflows.

For example, a company could record $100 in “revenue” from a customer because they billed and delivered a product to the customer, but they may not have received that $100 as a cash payment yet.

Another example is that a company could issue $50 in Dividends to its common shareholder investors, but this item does not appear on the Income Statement at all – even though it clearly affects the Cash balance.

So, to determine how the company’s Cash balance changes in these scenarios, you need the Cash Flow Statement to record these adjustments and additions.

Unlike the Income Statement and Balance Sheet, the presentation of the Cash Flow Statement also differs significantly under different accounting systems.

U.S.-based companies tend to use one method (the more straightforward one), while non-U.S. companies using IFRS tend to use more varied and inconsistent methods.

We’ll discuss those nuances here but, as always, we’ll start with a short summary:

Files & Resources:

• Cash Flow Statement – Summary and Presentation Slides (PDF)
• Monster Beverage – Financial Statements (PDF)
• Monster Beverage – Excel Version of the Cash Flow Statement in a Financial Model (XL)
• EasyJet – IFRS Financial Statement Examples (PDF)

Video Table of Contents:

• 0:00: Introduction
• 0:38: The Short Version
• 5:36: Part 1: U.S. GAAP vs. IFRS Differences and Requirements
• 7:11: Part 2: When Does An Item Appear on the CFS?
• 8:53: Part 3: CFS Forecasting in Financial Models
• 10:37: Part 4: The Cash Flow Statement in Interviews
• 12:51: Recap and Summary
• 13:48: Is the Cash Flow Statement King?

What is the Cash Flow Statement? What Are Its Different Sections?

Here’s a simple but representative Cash Flow Statement taken from the 3-statement modeling lessons in our Core Financial Modeling course:

The main sections and explanations are as follows:

Cash Flow from Operations (CFO) – This starts with Net Income at the top, adjusts for non-cash items, and then factors changes in operational Balance Sheet items change in the period (i.e., the Change in Working Capital).

Rough Proxy: CFO corresponds to Current Assets and Current Liabilities – but not exactly since Cash, Investments, and Debt do NOT show up here, as they are non-operational. Changes in Lease Assets and Liabilities (both long-term items) may appear here as well!

It’s best to think of this section as: “Net Income, non-cash adjustments, and changes in operational Balance Sheet items.”

Cash Flow from Investing (CFI) – Items related to financial investments, acquisitions, and Plants, Property & Equipment (PP&E) appear here.

Purchases are negative because companies spend cash on them, and sales are positive because they result in more cash.

Rough Proxy: CFI corresponds to Long-Term Assets – but not 100% because of how Lease Assets are treated and the fact that some financial investments may be short-term.

Cash Flow from Financing (CFF) – Items related to Debt, Dividends, and Issuing or Repurchasing Shares show up here. Various Lease-related items may also show up here.

Rough Proxy: CFF corresponds to Long-Term Liabilities and Equity… but, again, this is a rule of thumb rather than a universal law.

For example, some long-term liabilities, such as Deferred Tax Liabilities, are linked to adjustments in CFO rather than CFF.

Meanwhile, Common Shareholders’ Equity is affected not only by the items in this CFF section, but also by Net Income and Stock-Based Compensation in CFO.

Real-Life Cash Flow Statement Example and Template

Monster Beverage has a good, simple example of a Cash Flow Statement:

• Monster Beverage – Financial Statements (PDF)
• Monster Beverage – Excel Version of the Financial Statements (XL)

Here’s an image of the company’s version:

And here’s our version with several changes:

We tend to make several changes to the Cash Flow Statement for U.S. companies:

1. Consolidation – Several smaller items here have been consolidated into “Other Items” in CFO to make it easier to project and link the statements. We generally want each CFS line to correspond to a single BS line.
2. “What If” Items – Even if a company does not currently issue Dividends or issue/repay Debt, we often add these items to the model just in case something changes in the future or we want to try different scenarios.

The Cash Flow Statement Under U.S. GAAP vs. IFRS and the Direct Method

While there may be minor differences on the Income Statement between U.S. and international companies, there are much more significant differences on the Cash Flow Statement.

For example, IFRS-based companies often start the CFS with Operating Income or Pre-Tax Income rather than Net Income, or they use the Direct Method to create the CFS.

In other words, they show actual cash outflows and inflows rather than starting with Net Income and adjusting it (the “Indirect Method”).

And here’s an example of a Cash Flow Statement for an IFRS-based company – EasyJet in the U.K. – that still uses the standard breakout, but starts its Cash Flow Statement quite differently:

This statement is quite problematic.

First off, it’s impossible to link this to the Balance Sheet since changes to items like Accounts Receivable and Accounts Payable are not shown.

Second, “Cash Generated from Operations” doesn’t match any specific lines on the Income Statement.

Third, Dividends are listed in Cash Flow from Operating Activities.

Fourth, it’s not ideal to show changes to items like Money-Market Deposits and Restricted Cash on the CFS; they should be part of “Cash” on the Balance Sheet.

Finally, Net Interest and Taxes should appear on the IS and then be adjusted on the CFS.

When you encounter this type of Cash Flow Statement, you need to find a reconciliation between “Cash Generated from Operations” and Net Income and then modify the Cash Flow Statement.

For financial modeling purposes, the Cash Flow Statement should always start with Net Income and adjust from there.

Why Do Items Appear on the Income Statement vs. the Cash Flow Statement?

We receive many questions about why Item X appears on the Cash Flow Statement, while Related Item Y appears on the Income Statement, and Related Item Z appears on neither one.

For example:

1. Why do Common Dividends appear on the Cash Flow Statement in CFF, while Preferred Dividends appear on the Income Statement as a deduction near the bottom?
2. Why does CapEx appear on the Cash Flow Statement, while Depreciation appears on both the Income Statement and Cash Flow Statement?
3. Why do Debt Issuances and Principal Repayments appear on the Cash Flow Statement, while the Interest Expense itself appears on the Income Statement?

The short answer is that you should think about the rules and requirements for both statements:

• On the Income Statement, items must correspond to a delivery or allocation in the period.
• On the Income Statement, items must affect the income available to the common shareholders of the business (i.e., the owners).
• On the Cash Flow Statement, items must represent adjustments to non-cash items on the Income Statement or cash inflows/outflows that did not appear on the Income Statement.

With the first question, Preferred Dividends directly reduce the income available to the owners, which is why they are deducted in the Net Income to Common calculation.

The Preferred Stockholders always get paid first, before the equity owners, and these Preferred Dividends directly reduce how much could be distributed to the owners in the period.

Common Dividends also represent a payment made in the current period, but they do not affect the income available to the owners – because they are the distribution to the owners.

So, they represent a cash outflow that does not affect the income available to the common shareholders and is therefore not on the IS – which is why they’re on the CFS instead.

With the second question, CapEx does not appear on the Income Statement because it does not correspond only to the current period.

Items like factories, buildings, equipment are useful for many years, so this expense must be recognized over that time frame in the form of Depreciation, which does appear on the IS.

However, it is non-cash because it corresponds to the allocation of a previous cash outflow, so it also gets added back on the Cash Flow Statement in the CFO section.

With the third question, Debt Issuances and Debt Principal Repayments correspond to longer-term items because Debt typically remains outstanding for many years.

If a company issues Debt or repays some of it, that doesn’t just affect the current period – it changes the company’s obligations and Interest Expense going forward.

By contrast, the Interest Expense itself applies only to the current period and doesn’t affect the future.

Also, these Debt issuances and repayments do not directly affect the income available to the owners in the current period.

Therefore, Debt issuances and principal repayments are always shown on the Cash Flow Statement (for more, see our Debt Schedule tutorial).

Cash Flow Statement Forecasting in Financial Models

In financial models, you may build detailed schedules for Cash Flow Statement line items such as Depreciation, Deferred Taxes, and Capital Expenditures, but you could also simplify and make many of them percentages of revenue or expenses.

For example:

• Depreciation & Amortization: Often a simple % of revenue.
• Deferred Taxes: Can be a simple % of Book Taxes on the Income Statement.
• Stock-Based Compensation: Can be a % of revenue or total Operating Expenses.
• Change in Working Capital: All these items should flow in from the Balance Sheet, but you could make the overall Change in WC a percentage of the change in revenue if you lack Balance Sheet forecasts.
• Capital Expenditures: Often a simple % of revenue or the change in revenue.
• Purchases/Sales of Investments: These may be held constant or grown at modest rates.
• Dividends: Can be a simple % of Net Income.
• Stock Issuances/Repurchases: Often set to 0 or a constant number.
• Debt Issuances/Repayments: Often based on whether the company has a cash flow surplus or deficit; Debt is issued to fund a deficit or repaid if there’s a surplus.

The Cash Flow Statement in Accounting Interview Questions

In investment banking interviews, the Cash Flow Statement should be “the middle” of any accounting question.

In other words, you start with the changes on the Income Statement, then move to the Cash Flow Statement, and then finish with the Balance Sheet and explain how it remains in balance.

The Cash Flow Statement must come second because you need to trace the Income Statement first to explain how Net Income changes, and Net Income is the top line of the CFS in all these questions.

Also, to explain the Balance Sheet, you need to know the Net Change in Cash from the bottom of the Cash Flow Statement first.

For example, consider this question:

“A company records a $100 expense for a service that has been delivered, but it has not yet paid for this service. What happens on the statements?”

You always start with the Income Statement and then move to the others:

• Income Statement: The company’s Operating Expenses are up by $100, so Pre-Tax Income is down by $100, and Net Income is down by $75 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $75, but the company has not yet paid for this $100 expense in cash, so you add back the $100. Cash at the bottom is up by $25.
• Balance Sheet: Cash on the Assets side is up by $25. On the L&E side, Accounts Payable is up by $100 to represent this unpaid expense, and Shareholders’ Equity is down by $75 because of the Net Income reduction. Both sides are up by $25 and balance.

The intuition here is that the company gets a $25 tax benefit for recording this expense without yet paying for it in cash.

Is the Cash Flow Statement the One Financial Statement to Rule Them All?

Some people argue that the Cash Flow Statement is the “king of the financial statements” because it shows you how the company’s Cash changes.

They argue that the Income Statement is deceptive because of accrual accounting practices, and that the CFS provides much more insight into the true value of a company’s business.

In some sense, they are right: In valuation, cash flow is king because the discounted cash flow model represents the “true value” of most companies.

However, it’s not quite that simple for a few reasons:

1. In a DCF, the Unlevered Free Cash Flow metric is based on both the Income Statement and the Cash Flow Statement.
2. The Cash Flow Statement often has many irregular and non-recurring items; if you fail to exclude these, you will get a misleading view of a company’s cash flows.
3. The Cash Flow Statement does not provide much insight into a company’s core business because it doesn’t show the revenue and expenses directly, which makes it hard to tie it to unit-level forecasts.

If you were stranded on a desert island and had to evaluate a company with only one financial statement, yes, it would be the Cash Flow Statement.

But if you ever got off that desert island and had access to all the statements, you’d rely on all three major financial statements – along with management’s notes and other sources – to build a valuation.