The profit and loss statement (P&L) shows a profit, but the checking balance is lower than three months ago. A cash flow statement explains that contradiction—the P&L doesn't. Accrual profit doesn't mean the cash arrived. Unpaid invoices and pre-season inventory can drain the account while payroll keeps running.
Profit and cash follow different rules, so the two reports can disagree in the same quarter without anything being wrong with your books. To understand a cash drop, separate operating cash from growth spending and financing moves before deciding what changed. The three sections show whether cash came from customers, assets, debt, or owners.
What is a cash flow statement?
A cash flow statement tracks the cash that moved in and out of your business during a month, quarter, or year. It groups that cash under operating, investing, and financing activities. Unlike the income statement, which includes non-cash items like depreciation and revenue you haven't collected yet, the cash flow statement shows money that changed hands. It tells you whether the business generated enough cash to cover its obligations.
The gap between the two reports exists because the income statement follows accrual rules. It records revenue at the moment you earn it, well before the customer pays, and it deducts depreciation, an expense that reduces book value without reducing cash. You can post a solid profit while your bank balance falls.
The statement covers a set period, usually a month or quarter, and often a year-end period. It starts with the cash you began with, ends with the cash you've got now, and assigns every dollar in between to one of the three activity types. Separating cash by activity makes the statement useful for cash flow management, as well as reporting.
Cash pressure is common for small employer firms. Federal Reserve small-business reporting found that 77% of small employer firms experienced at least one financial challenge in the prior 12 months, most commonly rising costs and cash flow strain.
What are the components of a cash flow statement?
A cash flow statement organizes every cash movement into operating, investing, and financing activities. Each dollar that enters or leaves the business lands in one of the three sections. The section tells you what kind of cash movement you're looking at.
Operating activities
Cash generated or consumed by the core business. Customer payments come in; payroll, rent, supplier payments, inventory purchases, and taxes go out. Operating activities sit at the top of the statement because this section answers whether the core business can pay for itself without borrowed money or asset sales.
Investing activities
Cash spent on or received from long-term assets. Equipment and vehicle purchases land here, along with property transactions and any proceeds from selling them. Negative investing cash flow can be healthy for a growing company because it often means the business is buying capacity.
Financing activities
Cash moving between the business and the people who fund it. Loan draws, loan repayments, owner contributions, and owner distributions all sit in this section. Financing explains how any gap between operating cash and investing outflows was filled.
A $5,000 decline caused by an equipment purchase usually means the business bought capacity. The same decline caused by operations spending more than they collect means the core business is leaking. Negative operating cash flow across periods is rarely healthy.
Preparing a cash flow statement
To prepare a cash flow statement, gather your source reports first. Then choose the method your accounting system uses and work through the activity sections.
Collect the source data. Pull the income statement, beginning and ending balance sheets, and bank and loan statements.
Choose a method. The direct method records cash receipts and payments line by line. The indirect method starts with net income and adjusts for non-cash items and working-capital changes. QuickBooks Online and Xero produce indirect-method statements by default.
Calculate cash flow from operating activities. Start with net income, add back depreciation and amortization, then adjust for receivables, inventory, payables, and accrued expenses.
Calculate cash flow from investing activities. Record equipment, vehicle, and property purchases, plus proceeds from asset sales.
Calculate cash flow from financing activities. Include loan draws, line of credit advances, and owner contributions. Subtract principal repayments, owner distributions, and dividends.
Reconcile and validate. Add the section totals to get net change in cash, then tie ending cash to the balance sheet.
Review and analyze. Trace unusual lines back to the transactions before relying on the report.
Miscategorized transactions often make a statement misleading. An owner draw coded as an expense will understate profit and misplace cash between operating and financing. Relay lets you separate payroll, tax, and operating cash before transactions hit the books. Its QuickBooks Online and Xero connections send settled activity into the ledger regularly, so your bookkeeper's got less to sort from one pooled balance.
Direct vs. indirect method: which one will you use?
You'll likely use the indirect method because tools like QuickBooks Online and Xero generate that format by default. Two methods exist for building the operating section, and they differ in how they arrive at the same number.
Direct method | Indirect method | |
|---|---|---|
Starting point | Actual cash receipts and payments | Net income from the P&L |
How it's built | Lists customer collections, supplier payments, and payroll as cash moves | Adds back non-cash expenses like depreciation, then adjusts for balance-sheet changes |
Working-capital adjustments | Not required; cash movement is recorded directly | Required; receivables and inventory growth subtract cash, while higher payables add it back |
Ease of preparation | Tedious; most bookkeeping systems don't track transactions this way | Automatic in QuickBooks Online, Xero, and other accounting tools |
Who uses it | Rare in small business; sometimes required for IFRS compliance | Common in small business and large companies |
Both methods produce the same net cash from operations, so the choice comes down to presentation. If you use accounting software, you'll usually get the indirect method.
Cash flow statement example for a growing small business
In Q2, the business earned a profit, bought a delivery vehicle, drew on a line of credit, and ended with less cash. The statement uses the indirect method.
Line item | Q2 amount |
|---|---|
Operating activities | |
Net income | $64,000 |
Add back: depreciation | $18,000 |
Increase in accounts receivable | ($42,000) |
Increase in inventory | ($25,000) |
Increase in accounts payable | $15,000 |
Net cash from operating activities | $30,000 |
Investing activities | |
Purchase of delivery vehicle | ($48,000) |
Net cash from investing activities | ($48,000) |
Financing activities | |
Line of credit draw | $40,000 |
Loan principal repayment | ($12,000) |
Owner distribution | ($20,000) |
Net cash from financing activities | $8,000 |
Net change in cash | ($10,000) |
Beginning cash | $96,000 |
Ending cash | $86,000 |
The quarter earned $64,000 in profit but ended with $10,000 less cash. Receivables explain most of the gap: $42,000 of unpaid invoices and $25,000 of inventory absorbed cash. Depreciation added $18,000 back because it used no cash, and higher payables added $15,000, leaving operations with $30,000 generated.
Operating cash didn't cover the $48,000 vehicle purchase. The $40,000 line of credit draw, less the $12,000 repayment and $20,000 owner distribution, added $8,000. Because operations stayed positive, the cash drop points to a growth investment. Tracking cash flow metrics built from these lines turns one quarter's story into a trend you can compare across periods.
How do you read a cash flow statement? Red flags and green flags
Start with net cash from operating activities because it tells you whether the business funds itself. Then check whether operating cash covered the investing outflows. Financing comes last—it shows who filled any remaining gap.
Red flags
These patterns deserve a closer look before you treat the period as normal:
Operating cash flow negative for two consecutive periods. Check unpaid invoices, margins, and expense growth.
Financing inflows regularly exceeding operating cash flow. The business is running on borrowed money.
Receivables growing faster than revenue. Tighten invoice terms and work the aging report.
If any red flag repeats, trace it to the underlying transactions before making a cash decision.
Green flags
These patterns suggest cash is moving through the business in a healthier way:
Operating cash flow positive across several periods and covering investing outflows. The business funds its own growth without new debt or owner contributions.
Ending cash stable or growing while distributions continue. Reserves are coming from operations.
Payables and receivables moving in step with revenue. Working capital is growing with the business.
One strong period helps, but the trend matters more than a single line. Compare several periods before reacting to one number, especially if your cash reserve's thin. Use the statement to explain past cash changes, then use a forecast to plan the next payroll run, tax payment, inventory buy, or debt payment.
Put your cash flow statement to work
You can now see which section is driving the cash change and what to do next. A low balance turns into a more specific question. Did cash move into receivables or inventory, go toward a capital purchase, or leave through a financing decision?
Before your next cash decision, compare bank balance, receivables, inventory, and payroll timing. If you want those categories to exist as real balances instead of one pooled account, opening a Relay account lets you separate tax, payroll, and operating cash with up to 20 checking accounts on Starter and Grow plans (up to 50 on Scale), 2 savings accounts, and automated transfer rules.
Frequently asked questions
What is the difference between a cash flow statement and an income statement?
The income statement measures profitability under accrual rules, so it includes revenue you've billed but not collected and non-cash expenses like depreciation. The cash flow statement shows whether billed work has become cash you can spend.
How often should a small business review its cash flow statement?
Monthly at minimum. Accounting software generates the report automatically, so reviewing it takes a few minutes. Businesses with thin reserves or seasonal swings benefit from checking their cash position weekly between statements.
Do small businesses need a cash flow statement, or is it only for big companies?
Yes, small businesses need one. Private companies aren't required to file it, but the report matters when cash is tight because it shows whether day-to-day operations are producing cash or consuming it.
What is the easiest way to create a cash flow statement?
Generate it from your accounting software, which builds the indirect-method version from the books you already keep. Building one manually only makes sense if your records aren't in an accounting system yet.
Is negative cash flow always bad?
No. A negative total driven by an equipment purchase or debt paydown can describe a business investing in itself. Operations consuming cash period after period is the pattern that demands immediate attention—the core business isn't paying for its own obligations.
