5.3 Cash Flow Statement Analysis
Key Takeaways
- Indirect cash from operations starts at net income: Northline CFO = $100,000 + $40,000 D&A − $20,000 ΔNWC = $120,000.
- Ending cash = beginning cash + CFO + CFI + CFF; $50,000 + $120,000 − $70,000 + $20,000 = $120,000, which must equal the balance-sheet cash line.
- Earnings quality weakens when CFO is well below net income; a spike in receivables or inventory can produce profit without cash.
- Simple free cash flow = CFO − capex = $50,000; unlevered FCF = NOPAT + D&A − capex − ΔNWC = $70,000 because UFCF is before interest.
- Net income of $100,000 does not prevent a cash drain: if capex, NWC, debt repayments, and dividends exceed CFO, the firm can still run out of cash.
The Three Sections, in the Order a Modeler Reads Them
The statement of cash flows answers one question: why did the cash line on the balance sheet move? US GAAP and IFRS both present three sections, and FMVA models use all three:
- Cash from operations (CFO) — cash generated or used by the core business after working capital and, under typical US GAAP presentation, after cash interest and cash tax
- Cash from investing (CFI) — capital expenditure, asset sales, and purchases or sales of investments
- Cash from financing (CFF) — debt draws and repayments, equity issuance, dividends, and buybacks
The identity is not optional:
CFO + CFI + CFF = Change in cash
Ending cash = Beginning cash + change in cash
Ending cash on the cash flow statement must equal cash on the closing balance sheet. That is the same integrity check CFI drills in three-statement modeling. If it does not tie, a line is missing or a sign is reversed — usually ΔNWC, capex, or dividends.
Indirect CFO Starts at Net Income
Almost every FMVA case uses the indirect method for CFO. Direct-method CFO (cash collected from customers minus cash paid to suppliers) is rare in models and rare on the exam.
Indirect CFO walk:
- Start at net income (the accrual bottom line, which also flows to retained earnings).
- Add back non-cash expenses that reduced NI: depreciation, amortization, impairments, stock-based compensation.
- Subtract non-cash gains (for example a gain on sale of PP&E); the full proceeds belong in CFI.
- Subtract increases in operating current assets (AR, inventory, prepaids).
- Add increases in operating current liabilities (AP, accruals, deferred revenue).
- Steps 4–5 together are minus ΔNWC when NWC is defined as operating current assets minus operating current liabilities.
- Result = CFO.
You start at net income because that is the number that already closed to equity. The adjustments strip accruals until only operating cash remains. You do not start at EBITDA. EBITDA ignores interest, tax, and NWC. CFO includes those (interest and tax via the NI starting point in a standard US GAAP layout, NWC via the explicit adjustments).
Northline Year 1 income statement (for the walk)
| Line | Amount |
|---|---|
| Revenue | $1,200,000 |
| COGS | $720,000 |
| Gross profit | $480,000 |
| Cash SG&A | $290,000 |
| D&A | $40,000 |
| EBIT | $150,000 |
| Interest | $25,000 |
| EBT | $125,000 |
| Tax at 20% | $25,000 |
| Net income | $100,000 |
Capex is $70,000. Operating NWC rose $20,000 (Section 5.1 fuller definition). The firm drew a net $40,000 of debt (total debt $230,000 → $270,000) and paid $20,000 of dividends. Beginning cash was $50,000.
Worked Cash Flow Statement That Ties to Balance-Sheet Cash
| Cash flow line | Amount | Notes |
|---|---|---|
| Net income | $100,000 | Also added to retained earnings |
| + D&A | $40,000 | Non-cash; already in EBIT |
| − Increase in operating NWC | ($20,000) | AR, inventory, prepaids vs AP, accruals |
| CFO | $120,000 | |
| − Capex | ($70,000) | PP&E roll-forward |
| CFI | ($70,000) | |
| + Net debt issuance | $40,000 | Revolver and long-term debt |
| − Dividends | ($20,000) | Not an expense; CFF, not SG&A |
| CFF | $20,000 | |
| Change in cash | $70,000 | 120 − 70 + 20 |
| Beginning cash | $50,000 | Year 0 cash |
| Ending cash | $120,000 | Must equal Year 1 BS cash |
Check the other links at the same time, or the $120,000 cash tie is a coincidence.
Net income → retained earnings. Year 0 equity $320,000 + NI $100,000 − dividends $20,000 = $400,000 Year 1 equity. Dividends never hit the income statement.
PP&E roll-forward → CFI and D&A. Year 0 net PP&E $380,000 + capex $70,000 − D&A $40,000 = $410,000 Year 1. Capex is CFI, not an operating expense. D&A is an add-back in CFO, not a CFI inflow.
Debt roll-forward → CFF. Year 0 total debt $230,000 + net issuance $40,000 = $270,000. The issuance is a financing inflow. Principal repayment would be a financing outflow. Interest stays in NI (and therefore in the CFO starting point) under the usual US GAAP classification.
Balance sheet still balances. Year 1 assets: cash $120,000 + AR $120,000 + inventory $90,000 + prepaids $10,000 + PP&E $410,000 = $750,000. Claims: AP $60,000 + accruals $20,000 + revolver $40,000 + current portion $30,000 + long-term debt $200,000 + equity $400,000 = $750,000.
That is the whole three-statement system in one year of numbers. NI is the bridge from the income statement into both RE and the top of the cash flow statement. D&A is added back. ΔNWC is subtracted when it increases. Capex lives in CFI. Debt and dividends live in CFF. Ending cash is beginning cash plus the three sections.
CFO Versus Net Income: Quality of Earnings
Quality of earnings for a modeler is a cash question: did reported profit turn into cash from operations?
Northline: NI $100,000, CFO $120,000. CFO exceeds NI because D&A of $40,000 was non-cash and only $20,000 of that add-back was offset by an NWC build. Earnings converted to cash cleanly this year.
The red flag is the opposite: CFO well below NI. Suppose Northline had booked the same $100,000 of net income but AR had jumped an extra $60,000 on top of the actual increase (channel stuffing, bill-and-hold, or simply collections falling behind sales). ΔNWC would be $80,000 instead of $20,000, and CFO would be $100,000 + $40,000 − $80,000 = $60,000. Profit is $100,000; operating cash is $60,000. Accruals did the work.
Other ways CFO lags NI:
- Inventory build that outruns COGS (production without sales)
- Aggressive revenue recognition that inflates AR or understates deferred revenue
- Capitalizing costs that peers expense (NI higher; the cash may even sit in CFI as capex, which makes CFO look better and CFI worse — classification games)
- A large non-cash gain in NI that was not subtracted in the indirect walk
Exam trap: treating CFO below NI as automatic fraud. Growing firms often have CFO below NI because NWC scales with sales (Section 5.1). One year of CFO < NI with a documented AR days increase is a growth story or a collections story. Several years of NI rising while CFO stagnates is a quality-of-earnings problem. Pair the gap with DSO, DIO, and deferred revenue before you write the conclusion.
FCF Versus CFO Versus UFCF (Preview)
Three different cash figures will keep appearing through modeling and valuation. They are not substitutes.
CFO is cash from operations after interest and after operating NWC, before capex. Northline: $120,000.
Simple free cash flow (often called FCF or levered FCF in a pinch) = CFO − capex. Northline: $120,000 − $70,000 = $50,000. This is cash after funding the asset base, still after interest, before debt principal, dividends, and buybacks. It is a useful "cash the business produced after maintenance and growth capex" number. It is not the unlevered free cash flow a DCF discounts.
Unlevered free cash flow (UFCF / FCFF) is cash from operations before financing. CFI's definition, which you will build in the valuation chapters:
UFCF = NOPAT + D&A − capex − ΔNWC
NOPAT = EBIT × (1 − tax rate)
Northline: NOPAT = $150,000 × (1 − 0.20) = $120,000. UFCF = $120,000 + $40,000 − $70,000 − $20,000 = $70,000.
Why $70,000 instead of the $50,000 simple FCF? Simple FCF is after after-tax interest. Interest was $25,000; after-tax interest at 20% is $20,000. $50,000 + $20,000 = $70,000. UFCF puts the firm as if it were all-equity financed so you can discount at WACC and handle the debt in the EV-to-equity bridge (net debt) instead of in the cash flows.
Do not start UFCF at net income unless you add back after-tax interest (and adjust tax). Do not start it at CFO without the same add-back. Do not put capex in CFO. Do not forget ΔNWC — that $20,000 is as real a cash use in UFCF as it was in CFO.
| Measure | Northline Year 1 | Financing in the number? |
|---|---|---|
| Net income | $100,000 | After interest and tax |
| CFO | $120,000 | After interest; after NWC; before capex |
| Simple FCF (CFO − capex) | $50,000 | After interest and capex |
| UFCF | $70,000 | Before interest; after tax on EBIT, capex, NWC |
Profitable Firms Still Run Out of Cash
Net income is not a cash balance. Northline was profitable and cash-generative this year because capex was moderate, NWC grew only $20,000, and the firm issued $40,000 of debt. Change any of those and the story flips without touching the $100,000 of profit.
What-if: same NI and CFO, but a financing squeeze. Keep CFO at $120,000 and capex at $70,000. Replace the $40,000 debt issuance with an $80,000 principal repayment and keep the $20,000 dividend. CFF = −$80,000 − $20,000 = −$100,000. Change in cash = $120,000 − $70,000 − $100,000 = −$50,000. Beginning cash $50,000 + (−$50,000) = $0. The income statement still shows $100,000 of net income. The firm has no cash left. Next week's payroll is a liquidity event, not an earnings event.
What-if: growth capex. Keep financing as in the base case but raise capex to $180,000 (a plant expansion). CFI = −$180,000. Change in cash = $120,000 − $180,000 + $20,000 = −$40,000. Ending cash = $10,000. Still profitable. The expansion is an investing decision that the income statement will only recognize later as depreciation.
What-if: NWC blow-out. AR and inventory jump so ΔNWC is +$90,000. CFO = $100,000 + $40,000 − $90,000 = $50,000. After $70,000 of capex, simple FCF is −$20,000 before any dividend. A company can print a 8% net margin and still need the revolver because it financed customers and the warehouse instead of collecting cash.
This is the FMVA point, and it is why the cash flow statement is not a restatement of the income statement. Profit is necessary for long-run cash generation; it is not sufficient in any given year. The three-statement model exists to show the difference.
Integrity Checks Before You Trust the Ratios
Before you compute a current ratio or Debt/EBITDA from a model you built, run these five ties:
- Income statement → RE: ending RE = opening RE + NI − dividends.
- Indirect CFO starts at that same NI.
- ΔNWC on the CFS matches the change in operating current accounts, cash and debt excluded, sign = use if NWC rose.
- CFI capex matches the PP&E roll-forward; D&A is an add-back, not a CFI item.
- Ending cash on the CFS = cash on the BS = beginning cash + CFO + CFI + CFF.
If those five hold, Northline's 2.27x current ratio, 1.42x Debt/EBITDA, 6.0x interest coverage, and $120,000 of CFO are describing one company. If they do not hold, the ratios are theater. The FMVA final's Excel cases reward the ties more than they reward a memorized formula sheet.
Northline reports net income of $100,000, D&A of $40,000, and a $20,000 increase in operating NWC. Under the indirect method, what is cash from operations?
A company reports net income of $100,000 but cash from operations of $40,000 because accounts receivable and inventory jumped. What is the best interpretation?
Northline earns $100,000 of net income and $120,000 of CFO, with $70,000 of capex. If it also repays $80,000 of debt and pays $20,000 of dividends, what happens to cash?