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How does the statement of cash flows reconcile profit to the actual change in cash across operating, investing and financing activities?

Prepare a statement of cash flows and explain the three activity categories and the reconciliation of profit to cash

A focused answer to the H2 Principles of Accounting outcome on the statement of cash flows. Operating, investing and financing activities, the indirect-method adjustments to operating profit, and why profit differs from the change in cash.

Generated by Claude Opus 4.811 min answerUpdated 2026-06-06

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking
The answer
Examples in context
Try this

What this dot point is asking

SEAB wants you to prepare a statement of cash flows and to explain its three activity categories and how it reconciles profit to the change in cash. Because profit and cash differ, this statement answers the question the income statement cannot: where did the cash come from and where did it go? The central insight is that cash is grouped by the type of activity that generated it, operating, investing and financing, and that operating cash is found by adjusting profit for non-cash items and working-capital movements.

The answer

The three activity categories

Category	Contains	Typical flows
Operating	Cash from the main trading activities	Cash from customers, paid to suppliers and staff, interest and tax paid
Investing	Buying and selling non-current assets and investments	Purchase or sale of equipment, property
Financing	Raising and repaying long-term finance	Share issues, loans raised or repaid, dividends paid

The three categories sum to the net change in cash and cash equivalents, which reconciles the opening and closing cash balances.

The indirect method for operating cash

Operating cash flow is usually found by the indirect method, starting from operating profit and adjusting:

Add back non-cash expenses such as depreciation and loss on disposal (they reduced profit but used no cash).
Adjust for working-capital changes: an increase in inventory or receivables uses cash (deduct); a decrease releases cash (add); an increase in payables conserves cash (add), and a decrease uses cash (deduct).
Deduct interest paid and tax paid to reach net cash from operating activities.

\text{Operating cash} = \text{operating profit} + \text{depreciation} \pm \text{working-capital changes} - \text{interest} - \text{tax}

Why profit differs from cash

The statement makes visible why a profitable business may have less cash: profit is on the accrual basis (income recognised when earned, expenses when incurred), it excludes capital spending (an investing outflow), and it includes non-cash charges like depreciation. A company can earn good profit yet see cash fall because it bought assets, repaid loans or paid dividends, all of which the income statement ignores.

Worked example

Prepare a statement of cash flows from this data. Operating profit $\$ 160,000 $; depreciation$ \ $40\,000$ ; inventory rose $\$ 12,000 $; receivables rose$ \ $9\,000$ ; payables rose $\$ 7,000 $; interest paid$ \ $10\,000$ ; tax paid $\$ 24,000 $; equipment purchased$ \ $80\,000$ ; shares issued $\$ 50,000 $; dividends paid$ \ $30\,000$ . Opening cash $\$ 20,000$.

Step 1: Operating cash before interest and tax

Add depreciation; adjust working capital: $160\,000 + 40\,000 - 12\,000 - 9\,000 + 7\,000 = \$ 186,000$.

Step 2: Net cash from operating activities

Deduct interest and tax: $186\,000 - 10\,000 - 24\,000 = \$ 152,000$.

Step 3: Investing and financing

Investing: purchase of equipment $= -\$ 80,000 $. Financing: share issue$ +\ $50\,000$ less dividends $\$ 30,000 = +\ $20\,000$ .

Step 4: Net change and closing cash

\text{Net change} = 152\,000 - 80\,000 + 20\,000 = \$92\,000

Closing cash $= 20\,000 + 92\,000 = \$ 112,000 $. The statement shows strong operating cash of$ \ $152\,000$ , partly reinvested ( $\$ 80,000 $in equipment) and partly returned to owners, with a healthy$ \ $92\,000$ net rise in cash.

Examples in context

Example 1. The growing company that runs short of cash. A fast-expanding retailer reports rising profit but a falling bank balance. The statement of cash flows shows strong operating cash, but huge investing outflows on new stores and stock, plus loan repayments, exceed it. The statement diagnoses the squeeze precisely, revealing that growth is consuming cash, something the profitable income statement alone conceals.

Example 2. Reading quality of profit. Two firms report the same profit, but one generates ample operating cash while the other's profit is tied up in rising receivables and inventory, giving weak operating cash. An analyst trusts the first firm's profit more, because it converts into cash. The statement of cash flows thus tests the quality of reported profit, complementing the profitability ratios.

Try this

Q1. Classify these flows: sale of a building, cash paid to suppliers, loan raised. [3 marks]

Cue. Sale of a building - investing (inflow); cash paid to suppliers - operating (outflow); loan raised - financing (inflow).

Q2. Operating profit is $\$ 50,000 $, depreciation$ \ $10\,000$ , and receivables rose $\$ 4,000$. Find cash generated from operations (before interest and tax). [3 marks]

Cue. $50\,000 + 10\,000 - 4\,000 = \$ 56,000$ (add back depreciation, deduct the increase in receivables).

Q3. Explain why depreciation is added back in the operating section. [2 marks]

Cue. Depreciation reduced operating profit but involved no cash outflow, so it is added back to convert accrual profit toward the cash actually generated.

Exam-style practice questions

Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

Original8 marksCalculate the cash generated from operating activities using the indirect method. Operating profit

\

90\,000

; depreciation

20\,000

; inventory rose by

\

8\,000

; trade receivables fell by

5\,000

; trade payables rose by

\

3\,000

. Then deduct interest paid

6\,000

and tax paid

\

14\,000$ to find net cash from operating activities.

Show worked answer →

Start from operating profit and adjust for non-cash items and working-capital changes.

Operating cash flow (indirect method)	$\$ $
Operating profit	90,000
Add: depreciation (non-cash)	20,000
Less: increase in inventory	(8,000)
Add: decrease in receivables	5,000
Add: increase in payables	3,000
Cash generated from operations	110,000
Less: interest paid	(6,000)
Less: tax paid	(14,000)
Net cash from operating activities	90,000

Depreciation is added back as a non-cash expense. An increase in inventory uses cash (deduct); a decrease in receivables releases cash (add); an increase in payables conserves cash (add).

Cash from operations $= 90\,000 + 20\,000 - 8\,000 + 5\,000 + 3\,000 = \$ 110,000 $. After interest and tax, net cash from operating activities$ = 110,000 - 6,000 - 14,000 = \ $90\,000$ .

Markers reward adding back depreciation, the correct sign of each working-capital change, and the net operating cash of $\$ 90,000$.

Original6 marksClassify each cash flow as operating, investing or financing, and explain why a profitable company can still show a fall in cash: (a) purchase of equipment; (b) proceeds from issuing shares; (c) cash from customers; (d) dividends paid; (e) repayment of a loan.

Show worked answer →

Cash flow	Activity
(a) Purchase of equipment	Investing (outflow)
(b) Proceeds from issuing shares	Financing (inflow)
(c) Cash from customers	Operating (inflow)
(d) Dividends paid	Financing (outflow)
(e) Repayment of a loan	Financing (outflow)

A profitable company can show a fall in cash because profit is measured on the accrual basis while cash flow is not. Even with healthy operating cash, large investing outflows (buying equipment) and financing outflows (repaying loans, paying dividends) can exceed the cash generated, reducing the cash balance. Profit also ignores capital spending and includes non-cash items like depreciation.

Markers reward the correct classification of all five flows and a clear explanation that investing and financing outflows, plus the accrual-versus-cash difference, can reduce cash despite a profit.