Accrual accounting is a timing machine
Accrual accounting matches revenue to the period it was earned and costs to the period they were incurred. That produces a fair picture of performance, but it deliberately separates performance from cash. A sale on 30-day terms is revenue today and cash next month. Inventory bought today is an asset, not an expense, until it sells.
None of that is dishonest. It is simply a different question. Profit asks whether the business created value. Cash asks whether the business is still alive.
The three sections of the cash flow statement
A cash flow statement sorts every movement of money into three buckets, and reading them together tells a story about the firm's stage and its health.
- Operating cash flow: cash from customers less cash paid to suppliers and staff. This is the number that should be positive and growing.
- Investing cash flow: cash spent on or received from long-term assets. Usually negative for a growing firm, and that is fine if it is buying future capacity.
- Financing cash flow: cash from or repaid to lenders and owners. Positive when the firm raises, negative when it returns or repays.
The pattern matters more than any single number: profitable firms should show operating cash. Firms that never do are borrowing time.
Working capital is the usual culprit
When profit and cash diverge, the gap almost always lives in working capital. Receivables stretch because customers are slow. Inventory builds because forecasts were optimistic, or because a supply chain forced a bulk order. Payables shrink because a supplier demanded earlier payment.
Each of those ties up cash that the profit statement never sees. A firm can grow itself into a crisis this way: every extra sale needs more inventory and more receivables than the last, so fast growth consumes cash even as reported profit rises.
A reconciliation habit
The most useful exercise in financial analysis is to take net income and walk it, line by line, to the change in cash. Add back non-cash charges such as depreciation. Subtract the increase in receivables and inventory. Add the increase in payables. What is left should be operating cash flow.
If the walk produces a surprise, that surprise is the analysis. It is pointing at the part of the business that is quietly consuming money.
Sources and further reading