A cash flow statement shows where your money actually came from and went during the year, split into operating, investing and financing activities. It starts with net profit and adjusts for non-cash items and balance sheet movements, so it explains exactly why a profitable year can still leave less in the bank.

It is the third of the three reports, and in twenty years of looking at small business files I have almost never met an owner who reads it. Which is a shame, because it is the only report that answers the question they actually care about: we made money, so where is it?

I am Mina Baselyous, a Certified Practising Accountant (CPA) and Chartered Tax Advisor (CTA) in Melbourne. This article builds a complete cash flow statement from a real set of numbers, line by line, and shows how a business that made $135,000 of profit after tax finished the year with $43,000 less in the bank.

The Third Report, and Why It Matters Most

Your profit and loss tells you whether you traded profitably. Your balance sheet tells you what you are worth. The cash flow statement is the bridge between them: it takes the profit figure and explains, item by item, why the bank account did something different. It is the report that turns two abstract statements into one story you can act on.

The reason it exists is that accounting profit is measured on an accruals basis. Revenue is recognised when you invoice, not when you are paid. Expenses are recognised when incurred, not when the money leaves. Buying a $140,000 machine barely touches your profit in year one, while paying down $80,000 of loan principal does not touch it at all. None of that is visible on a profit and loss.

If you have not read our companion guide to reading a balance sheet, start there. This article uses the same business and the same numbers, so the two reports tie together exactly as they do in a real set of financial statements.

The Three Sections

Every cash flow statement has the same three sections, and the split is the whole point. Operating activities show the cash your trading actually generated. Investing activities show what you spent on assets. Financing activities show money moving between the business, its lenders and its owners. Three sections, three completely different meanings.

Operating Activities

This is the engine. It starts with net profit, adds back non-cash expenses such as depreciation, then adjusts for the movement in working capital: debtors, stock and creditors. A business that cannot generate positive cash from operations year after year is not a business, it is a hobby funded by the bank.

The logic of the working capital adjustments is simple once you see it. If debtors went up, you invoiced more than you collected, so subtract the increase. If stock went up, you bought more than you sold, so subtract it. If creditors went up, you received goods you have not paid for yet, so add it back. Money you are holding for the ATO in GST and PAYG works the same way.

Investing Activities

This section captures the full cost of buying assets and the full proceeds of selling them. It is where the difference between profit and cash is often most brutal, because a $140,000 equipment purchase leaves the bank account immediately while only the depreciation on it appears in profit.

Negative investing cash flow is not a bad sign in itself. A growing business should be investing. What matters is whether the operating section is generating enough to fund it, or whether you are borrowing to buy assets while trading is going backwards.

Financing Activities

Financing covers new borrowings, repayments of loan principal, capital introduced by owners, dividends and drawings. This is the section where the loan principal finally appears, having been completely invisible on the profit and loss, and it is usually the line that explains the last chunk of a missing bank balance.

The Worked Example, Line by Line

Same Melbourne trade and services company as the balance sheet guide: $2.4 million of sales, $180,000 of profit before tax, $45,000 of income tax at the base rate entity rate of 25 per cent, leaving $135,000 of profit after tax. Cash went from $85,000 down to $42,000. Here is the reconciliation.

Read the three subtotals and you have the whole year in three numbers. Trading generated $103,000 of real cash. The business spent $140,000 on equipment. It took $6,000 net out through financing. Result: $43,000 less in the bank, on a $135,000 profit. Nothing is missing, nothing was stolen, and the bookkeeper did not make a mistake.

The Four Things That Eat Profit Without Touching It

Four items consume cash but never appear as an expense on your profit and loss: increases in debtors and stock, purchases of assets, repayments of loan principal, and dividends or drawings. Together they explain almost every gap between a profit figure and a bank balance. Learn these four and the mystery disappears permanently.

• Debtors and stock. $150,000 in this example. Every dollar of growth in these lines is a dollar of profit you earned but have not collected or sold yet. This is the working capital cycle, and we cover how to shrink it in our guide to working capital.
• Capital purchases. $140,000 here, against only $60,000 of depreciation in the profit and loss. The other $80,000 left the bank but will only be deducted in later years.
• Loan principal. $80,000 here. The business paid the bank $120,000 during the year, being $80,000 of principal and $40,000 of interest, but only the $40,000 of interest was deductible. The principal is a repayment of borrowed capital, not an expense.
• Dividends and drawings. $46,000 here. Money taken out by the owners is a distribution of profit, not a cost of earning it, so it never reduces the profit figure.

In practice, says Mina Baselyous (CPA, CTA, Registered Tax Agent), the loan principal line is the one that causes the most arguments. An owner is certain the bank took $120,000 off them, and they are right, but their accountant only claimed $40,000, and they are also right. Nobody has ever explained the difference to them.

How to Read a Cash Flow Statement in 60 Seconds

Ignore the detail on the first pass and read only the three subtotals. Operating should be positive and, over time, larger than your profit. Investing will usually be negative in a growing business. Financing tells you whether you funded the year from the bank or from the owners. The pattern across the three is the diagnosis.

• Operating positive, investing negative, financing negative. The healthy pattern. Trading funds the assets and pays down debt.
• Operating positive but small, investing heavily negative, financing heavily positive. Growth funded by debt. Sustainable only while the bank stays comfortable.
• Operating negative. The business is consuming cash to trade. Whatever the profit says, this needs attention immediately.
• Operating positive only because creditors and the ATO balance grew. This is the dangerous one. It looks like cash generation but it is borrowed from suppliers and the Commissioner, and it reverses.

That last pattern deserves emphasis. In our example, $43,000 of the $103,000 operating cash flow came from the increase in creditors, GST, PAYG and tax payable. Strip that out and trading generated $60,000, not $103,000. When you see an operating result propped up by growing payables, you are looking at deferred pain, not performance.

Getting One for Your Own Business

Most accounting software will produce a statement of cash flows, and most annual financial statements for a proprietary company include one. If yours does not, ask for it. Building it manually is not difficult either: you need this year’s and last year’s balance sheet, and the profit and loss.

• Start with net profit after tax from the profit and loss.
• Add back depreciation and amortisation.
• Subtract increases, or add decreases, in debtors, stock and prepayments.
• Add increases, or subtract decreases, in creditors, GST and PAYG payable, accruals and tax payable.
• Subtract asset purchases and add asset sale proceeds.
• Add new borrowings, subtract principal repayments, subtract dividends and drawings.
• The total must equal the movement in your bank accounts. If it does not, something in the ledger is wrong.

That last line is the value of doing this. The cash flow statement is self-checking. If it does not reconcile to the actual bank movement, you have found a coding error, a missing transaction or an unreconciled account, which is why we always start with a clean bank reconciliation before producing management reports.

What to Do Next

Ask for a cash flow statement for the last two financial years and read the three subtotals. If operating cash flow is consistently below your net profit, the gap is going into debtors, stock, or the ATO balance, and every one of those is fixable with process rather than sales.

Then look forward rather than back. A historical cash flow statement explains the past; a rolling cash flow forecast tells you whether you can afford next quarter’s equipment purchase and your June tax bill at the same time. That forecast sits alongside your budget and is a standard part of a Virtual CFO engagement.

One structural fix worth checking at the same time: if your customers pay slowly, reporting GST on a cash basis stops you funding the ATO ahead of your own collections. Our guide to GST cash vs accruals sets out who is eligible and what it is worth.

Frequently Asked Questions

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