2.1.5 The Cash Flow Statement

Welcome to On Judgement. Harbour earns £24m profit but has only £9m free cash flow under a stated convention. Has money disappeared, or could the accounts explain the difference? Take a first view. You can change it when you have considered the evidence.

The cash-flow statement groups cash movements into operating, investing and financing activities under the relevant reporting basis. Non-cash transactions are not cash flows simply because an asset or liability changed. Opening cash plus the reported movements, including exchange effects where relevant, reconciles to closing cash and cash equivalents. Read the reconciliation and classification policies rather than assuming every company uses identical presentation.

An indirect bridge adjusts a specified profit subtotal for non-cash items and relevant timing differences. Depreciation is added back because it reduced profit without a current cash payment. Growing receivables and inventory often absorb cash; a rise in trade payables can temporarily provide it. The simplified signs are useful, but acquisitions, currency and write-downs can complicate balance-sheet comparisons.

Buying equipment uses cash and can support future sales; distinguish maintenance from expansion and assess returns. Debt issues and share issues provide financing; repayment, distributions and buybacks consume it. A negative investing total is not automatically healthy growth, and negative financing is not automatically confidence. Ask what was funded, on what terms, and whether future obligations remain affordable.

For this module, simple FCF = operating cash flow minus total equipment capex. It is a stated convention, not the unlevered valuation cash flow used later. Do not subtract maintenance capex twice. Persistent weak conversion prompts questions about collections, inventory, taxes and expenditure timing. Positive cash flow can also be flattered by delayed payments or postponed investment, so one year rarely settles quality.

Let's work through Harbour’s cash bridge · £m. Use net profit 24, depreciation 6, receivables increase 8, inventory increase 4 and payables increase 3. Assume these are the only operating reconciliation items. Equipment capex is 12, new debt 5, debt repayment 4 and cash dividends 6. Opening cash is 26; no FX or other flows. Pause here and try the calculation or reasoning before continuing.

Operating cash flow = 24 + 6 − 8 − 4 + 3 = 21. Simple FCF = 21 − 12 = 9. Financing flow = 5 − 4 − 6 = −5. Net cash movement = 21 − 12 − 5 = 4; closing cash = 26 + 4 = 30.

Profit exceeds operating cash by £3m under these assumptions. Investigate the working-capital drivers and future collections; the difference is not proof of fraud.

Now try the choices in this lesson. If your answer changes, identify the reason. Investigate cash conversion without assuming misconduct. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.