The big picture
- The income statement measures profit over a period, using accrual accounting.
- The cash flow statement starts with that profit (net income) and adjusts it to show the cash that actually moved.
- The balance sheet shows what the company owns and owes at a point in time, and its cash balance comes from the cash flow statement.
Step 1: Start with net income
Net income is the top line of the cash flow statement. But it includes non-cash items and ignores cash that's tied up in the business, so we adjust it.
Step 2: Cash flow from operations
- Add back non-cash expenses like depreciation, amortization and stock-based compensation.
- Adjust for working capital. An increase in accounts receivable or inventory uses cash (you've sold or bought something but the cash hasn't moved the same way). An increase in accounts payable or accrued expenses provides cash (you've recorded a cost but haven't paid it yet).
Step 3: Cash flow from investing
Mostly capital expenditures (buying PP&E), plus acquisitions and purchases or sales of investments. Capex is usually the big one, and it's always a use of cash.
Step 4: Cash flow from financing
Cash raised from or returned to investors and lenders: borrowing and repaying debt, issuing or buying back shares, and paying dividends.
Step 5: Ending cash goes to the balance sheet
Beginning cash + operating + investing + financing cash flow = ending cash. That ending cash becomes the cash line on the balance sheet.
A worked example
| Cash flow statement | $ |
|---|---|
| Net income | 100 |
| + Depreciation | 20 |
| − Increase in accounts receivable | (15) |
| − Increase in inventory | (10) |
| + Increase in accounts payable | 5 |
| Cash flow from operations | 100 |
| Capital expenditures | (40) |
| Cash flow from investing | (40) |
| Debt repaid | (20) |
| Dividends paid | (10) |
| Cash flow from financing | (30) |
| Net change in cash | 30 |
| Beginning cash | 50 |
| Ending cash (to balance sheet) | 80 |
Notice that this company earned $100 of net income and ended up with exactly $100 of operating cash flow, but only because the $20 depreciation add-back happened to offset the $20 of net working capital it absorbed. Change any of those and profit and cash diverge.
How the balance sheet still balances
Every line on the cash flow statement matches a change on the balance sheet:
- Net income less dividends → retained earnings up $90
- Depreciation and capex → PP&E up $20 (+40 − 20)
- Receivables, inventory and payables → working capital lines
- Debt repaid → debt down $20
- Everything nets to cash up $30
Check: assets rise by cash 30 + AR 15 + inventory 10 + PP&E 20 = $75. Liabilities and equity rise by AP 5 − debt 20 + retained earnings 90 = $75. Balanced.
Why this matters for LBOs: in a leveraged buyout, cash flow from operations minus capex is what repays the debt. Every working capital assumption flows straight into how fast the sponsor deleverages and what IRR it earns.
Practice it hands-on
The free “Free cash flow” lesson builds this step by step in a live spreadsheet.