A business can report a profit and still run out of money. It happens more often than people expect. Accounting profit includes estimates, timing choices and non-cash items. Cash is simpler: it either arrived or it did not.
The cash flow statement tracks the actual movement of money in and out of a business over a period. Warren Buffett and the Interpretation of Financial Statements treats it as the place where the claims made on the income statement are tested. This article explains how the statement is built, how to read it, which patterns signal strength or weakness, and why cash flow is the measure that matters most to anyone running a small or growing business.
Why profit and cash differ
Accounting profit follows the accrual principle: revenue is recorded when it is earned and expenses when they are incurred, regardless of when money changes hands. That gives a better picture of performance over a period, but it means profit and cash can diverge for many reasons:
- A sale made on 60-day terms counts as revenue today but produces cash in two months.
- Stock bought this month is paid for now but expensed only when sold.
- A new machine is paid for upfront but expensed gradually as depreciation.
- Tax may be paid in instalments that do not match the year’s profit.
- Loan repayments use cash but are not an expense at all.
Over a long enough period, a healthy business’s cash flow and profit should broadly agree. In any single period they can differ substantially, and persistent gaps are worth investigating.
The three parts of the statement
The cash flow statement is divided into three sections:
- Operating activities: cash generated by the day-to-day business. It includes receipts from customers, payments to suppliers and employees, interest and tax, depending on how the company presents them.
- Investing activities: cash spent on, or received from, long-term assets such as equipment, property, acquisitions and investments. Capital expenditure appears here.
- Financing activities: cash raised from, or returned to, lenders and owners: borrowing, repaying debt, issuing shares, buying shares back and paying dividends.
Read together, they answer three questions: does the business generate cash, what does it spend it on, and where does the rest go?
Direct and indirect presentation
Operating cash flow can be presented in two ways. The direct method lists actual receipts and payments: cash received from customers, cash paid to suppliers and employees. Australian companies commonly use this presentation and then provide a reconciliation to profit in the notes.
The indirect method starts with net profit and adjusts it: adding back non-cash expenses such as depreciation, and adjusting for changes in working capital. The reconciliation is particularly useful because it shows exactly why profit and operating cash flow differ.
A simplified example
Here is an illustrative cash flow statement for a manufacturing business, presented using the indirect method for operating activities.
| Amount | |
|---|---|
| Operating activities | |
| Net profit | $5.0m |
| add depreciation | $1.5m |
| less increase in receivables | −$1.2m |
| less increase in inventory | −$0.8m |
| add increase in payables | $0.4m |
| Net cash from operating activities | $4.9m |
| Investing activities | |
| Purchase of plant and equipment | −$2.0m |
| Proceeds from sale of old equipment | $0.2m |
| Net cash used in investing activities | −$1.8m |
| Financing activities | |
| Repayment of borrowings | −$1.0m |
| Dividends paid | −$1.5m |
| Net cash used in financing activities | −$2.5m |
| Net increase in cash | $0.6m |
This business converts its profit into operating cash almost fully. It spends a moderate amount on equipment, repays some debt, pays a dividend and still adds to its cash balance. The pattern is healthy.
What a strong pattern looks like
From the book’s perspective, the pattern of a business with a durable advantage tends to be:
- Strong, consistent operating cash flow, broadly in line with reported earnings over time.
- Modest capital expenditure relative to earnings, so a large share of operating cash is genuinely free. The book suggests that consistently spending less than about half of net earnings on capital expenditure is a good sign, and less than a quarter even better.
- Cash returned to owners through dividends or share buybacks, funded by operations rather than borrowing.
- Little need for new financing, since the business funds itself.
A weak pattern looks different: operating cash flow that lags behind reported profits, heavy and recurring capital expenditure, and financing activities that keep bringing in new debt or new shares just to fill the gap.
Reading the three sections together
A quick way to read any cash flow statement is to note the sign of each section:
| Operating | Investing | Financing | What it often suggests |
|---|---|---|---|
| Positive | Negative | Negative | Mature, self-funding business investing and returning cash |
| Positive | Negative | Positive | Growing business investing more than it generates |
| Negative | Negative | Positive | Early-stage or struggling business relying on outside money |
| Negative | Positive | Positive or negative | Business selling assets to survive |
These are tendencies, not rules. A young company with negative operating cash flow may be building something valuable. But a long-established business that repeatedly needs financing to fill a gap is telling you something.
When profit and cash diverge
A persistent gap between reported profit and operating cash flow deserves attention. Common causes include:
- Receivables growing faster than sales, which suggests profits recorded on sales that have not been paid for.
- Inventory building up, which turns cash into unsold stock.
- Capitalised costs, where expenses such as development or software costs are recorded as assets rather than expenses, raising profit while the cash still leaves the business (appearing in investing rather than operating activities).
- Aggressive accounting, where revenue or costs are recognised in ways that flatter the income statement.
None of these is automatically sinister, but each means the profit figure is promising cash that has not yet appeared. A useful check is the ratio of operating cash flow to net profit over several years. Consistently near or above one is reassuring. Consistently well below one deserves an explanation.
Free cash flow and owner earnings
Behind all of this is a practical question: how much cash could the owners take out each year without harming the business?
A common answer is free cash flow: operating cash flow minus capital expenditure. It shows the cash left after the business has funded its operations and its investment in assets.
Buffett has written about a related idea under the name owner earnings: roughly, reported earnings plus depreciation and other non-cash charges, minus the capital spending needed to maintain the business’s competitive position and volume. The distinction from free cash flow is subtle but important. Owner earnings deducts only maintenance capital spending, not growth spending, because growth spending is a choice the owners could decline.
Businesses that produce high owner earnings relative to their reported profits are rare and valuable. Businesses whose reported profits are consumed every year by necessary reinvestment may never produce much for their owners, however good the income statement looks.
Reading ten years of cash flows
As with every statement in the book, the real insight comes from many years side by side. A simple table makes patterns visible:
| Measure | Year 1 | Year 2 | … | Year 10 |
|---|---|---|---|---|
| Net profit | ||||
| Operating cash flow | ||||
| Capital expenditure | ||||
| Free cash flow | ||||
| Dividends and buybacks | ||||
| Net borrowing |
Over a decade, a strong business’s operating cash flow tracks its profit, capital expenditure stays modest, free cash flow funds distributions, and net borrowing is small or negative. A weak business shows the opposite: a widening gap between profit and cash, heavy capital spending, and repeated borrowing.
What this means for a growing business
For a small business, cash flow is not an analytical exercise but a matter of survival.
Forecast cash, not just profit. A profitable order paid in 90 days can still leave you unable to pay this month’s bills. A rolling cash forecast, often thirteen weeks ahead, shows when pressure points will arrive while there is still time to act.
Know your cash conversion cycle. How long does it take from paying suppliers to being paid by customers? Shortening it frees money without any new sales.
Separate maintenance spending from growth spending. Only the second is optional. Knowing which is which shows what the business truly earns.
Fund growth from operations where possible. Every time financing fills the gap, the business becomes a little more dependent on others.
Plan for tax and lumpy payments. Quarterly tax instalments, annual insurance premiums and equipment replacements should appear in the forecast long before they fall due.
Watch the gap between profit and cash. If the business is profitable but cash keeps falling, find out why before it becomes urgent.
Money that is not yours
Australian small businesses face a particular cash trap. A business registered for GST collects GST on its sales and must pay it to the Australian Taxation Office, usually monthly or quarterly through the Business Activity Statement. Amounts withheld from employees’ wages under PAYG withholding, and superannuation guarantee contributions, must also be paid on time.
All of this money passes through the business bank account, and it is easy to treat a healthy balance as available cash when part of it belongs to the tax office and to employees’ super funds. A simple discipline is to move GST, withholding and super into a separate account as they accrue, so the main balance shows what the business can genuinely spend. Check current obligations and due dates with an accountant or the ATO.
A worked example
A small software consultancy grows quickly by taking on larger clients. This is an illustration.
Its income statement looks excellent: revenue up 50%, healthy margins, rising profit. But its cash balance keeps falling. The owner prepares a simple cash flow statement and a reconciliation to profit.
The reconciliation shows that receivables have more than doubled. Larger clients pay on 60-day terms and often take longer, while the consultancy pays its staff fortnightly. Every new project means paying salaries for two to three months before any cash arrives. Profit is real, but it is sitting in clients’ bank accounts.
The owner makes three changes: new contracts include an upfront deposit and monthly progress billing; invoices are issued on the day milestones are reached rather than at month end; and a modest finance facility is arranged as a buffer rather than as working capital. Over the next six months, operating cash flow catches up with profit, and the business continues growing without cash stress.
Common mistakes
Assuming profit means cash. It does not, especially in a growing business.
Ignoring working capital changes. They are often the biggest difference between profit and cash.
Treating all capital spending as optional. Some of it is the cost of staying in business.
Funding operating shortfalls with debt indefinitely. It postpones the problem and adds interest.
Looking at one year. Cash flow, like profit, is best judged over many years.
Questions to ask
- Does operating cash flow track net profit over several years?
- How much of operating cash flow is consumed by capital expenditure?
- Are dividends and buybacks funded by operations or by borrowing?
- What is the business’s free cash flow, and its owner earnings?
- For your own business: what will your bank balance be in thirteen weeks, and what could change it?
Bringing it together
The cash flow statement strips away accounting estimates and shows what actually happened to the money. Strong businesses generate cash consistently, spend modestly to maintain their position, and return the surplus to their owners without needing to borrow. Weak businesses show profits that never quite turn into cash.
Profit tells you whether the business works on paper. Cash flow tells you whether it works in practice.
Source: Mary Buffett and David Clark, Warren Buffett and the Interpretation of Financial Statements (2008). Owner earnings is described in Warren Buffett’s letters to Berkshire Hathaway shareholders. Figures in this article are illustrations, not data. This article is general information, not financial or investment advice.
