Why the statement of cash flows has three sections

What the balance sheet cannot tell you

The balance sheet shows a business at one moment, and cash is one of its assets. Compare two balance sheets and you can see how much cash changed. You cannot see why. Grant's video on this topic uses a simple case: cash is $100,000 at the start of the year and $150,000 at the end. The balance sheet says cash rose by $50,000. It does not say where the $50,000 came from.

An owner, a lender or an investor needs the why. The statement of cash flows supplies it. It starts with the beginning cash balance, adds the net change in cash for the period, and ends at the cash on the closing balance sheet. In between, it lists the sources and uses of cash, and it sorts them into three groups by what the cash was for:

• Operating activities. Cash from making and delivering the goods or services the business sells, and earning its profit: collections from customers, payments to suppliers and employees.
• Investing activities. Cash spent on, or received from, long-term assets and investments: buying equipment, selling an old van, buying another company's bonds.
• Financing activities. Cash raised from, or returned to, the people who fund the business: borrowing and repaying loans, issuing shares, paying dividends, buying back shares.

Grant's video frames the three groups the same way. Under US GAAP, ASC 230 lists which receipts and payments go in each group. Operating is the default: any receipt or payment that is not investing or financing is operating (ASC 230-10-45-16(c) and 45-17(f)).

A worked example

This example is hypothetical. Its opening and closing cash follow Grant's video. Maple Bakery keeps its books on a calendar year. Its cash is $100,000 on January 1 and $150,000 on December 31. During the year:

• It collects $400,000 from customers and pays $290,000 to suppliers and employees.
• It pays its bank $26,000: $20,000 to reduce the loan and $6,000 of interest.
• It pays $24,000 of income taxes.
• It buys a new oven for $60,000 in cash and sells an old delivery van for $12,000 in cash.
• It borrows a new $50,000 loan.
• It pays its owners $12,000 of dividends.

Each item goes to the section the ASC 230 lists assign it to:

Operating: $400,000 − $290,000 − $6,000 − $24,000 = $80,000. Investing: −$60,000 + $12,000 = −$48,000. Financing: $50,000 − $20,000 − $12,000 = $18,000. Together: $80,000 − $48,000 + $18,000 = $50,000, the change the balance sheet showed.

1. Cash, January 1 (opening balance sheet)$100,000
2. Operating activities+$80,000

   $400,000 collected − $290,000 to suppliers and staff − $6,000 interest − $24,000 taxes.

3. Investing activities−$48,000

   $60,000 oven bought − $12,000 old van sold.

4. Financing activities+$18,000

   $50,000 new loan − $20,000 loan principal repaid − $12,000 dividends.

5. Cash, December 31 (closing balance sheet)$150,000

Grey bars are totals. Green bars with a plus sign add; clay bars with a minus sign subtract. The thin line marks zero.

The balance sheet shows only the two ends: $100,000 and $150,000. The three sections explain the $50,000 in between.

The table lists each receipt and payment, which is the direct method. Many companies instead build the operating section by starting from net income, the indirect method that the indirect method page explains. The operating total is the same either way, and the investing and financing sections do not change.

One payment, two sections

The $26,000 paid to the bank is a single payment, but it is not a single kind of cash flow. Repaying the money borrowed reverses the loan, so the $20,000 of principal is a financing outflow (45-15(b)). The $6,000 of interest is listed among operating outflows (45-17(d)), alongside payments to suppliers and employees.

Account	Debit	Credit
Loan payable (principal)	$20,000
Interest expense	$6,000
Cash		$26,000
Totals	$26,000	$26,000

One payment, two sections: the $20,000 of principal is a financing outflow and the $6,000 of interest is an operating outflow.

Why the split matters

The net change in cash on its own can mislead, because very different years produce the same number. Here is Maple Bakery beside a second hypothetical bakery whose cash also rose from $100,000 to $150,000:

Second bakery: −$30,000 + $20,000 + $60,000 = $50,000. Both rose by $50,000, and the two years tell opposite stories. Maple Bakery's operations produced $80,000 of cash, enough to buy its new oven and pay dividends. The second bakery's operations used $30,000, and its cash rose only because it sold $20,000 of equipment and raised $60,000 of new money. It could not repeat that every year: equipment runs out, and lenders want to be repaid.

That is what the three sections are for. They separate cash the business produces by doing its work from cash it moves into or out of long-term assets, and from cash it raises from or returns to its funders. A reader can then ask the useful questions: can operations pay for the assets the business needs, and is the rest being paid for by borrowing, selling assets or the owners?

The cases people get wrong

Interest paid is operating, but the loan is financing. Under US GAAP, interest payments to lenders are operating outflows (45-17(d)), while borrowing and repaying principal are financing. So operating cash flow is measured after interest. When comparing two businesses that carry very different amounts of debt, keep in mind that the one with more debt pays more interest, and that interest reduces its operating cash flow.

Interest and dividends received are operating. Cash received as interest on loans the business has made, or as dividends on shares it holds, is an operating inflow (45-16(b)). Buying or selling the loans and shares themselves is investing (45-12 and 45-13).

Dividends paid are financing. A dividend returns cash to the owners, who are among the business's funders, so it is a financing outflow (45-15(a)). So is a share buyback, which 45-15(a) describes as reacquiring the entity's own equity instruments. Neither is an expense, and neither reduces net income.

Buying equipment is investing, unless the seller lends the money. Paying for equipment at or near the time of purchase is an investing outflow (45-13(c)). If the seller finances the purchase instead, no cash moves when the equipment arrives. That purchase is a noncash investing and financing transaction (50-4 gives buying a building with a mortgage to the seller as an example), and the later payments of principal to the seller are financing outflows (45-13(c)).

A common misconception

The usual mistake is to read the signs as grades: a positive section is good and a negative one is bad. Negative investing cash usually means the business bought long-term assets, which a growing business does. Positive financing cash means the business raised money, which may be a sign of strength or of need. Maple Bakery's investing section is negative because it bought an oven. The second bakery's investing section is positive because it sold equipment. Read each section for what produced it, not for its sign.

A second mistake is to treat "investing" as investing in the stock market. In the statement of cash flows, investing covers the business's own long-term assets, such as an oven or a building, as well as loans to and securities of other entities.

Where this stops

• This page covers the main lists, not every rule. ASC 230 has detailed rules for specific items, such as securities and loans acquired for resale (45-18 and 45-21), insurance proceeds and contingent consideration in a business combination. Interest that is capitalized as part of an asset's cost is part of the investing outflow for that asset (45-13(c)).
• Cash includes cash equivalents. Real statements reconcile cash and cash equivalents. What counts as a cash equivalent has its own definition, which this page does not cover.
• The Codification text was read through FASB's Update. The paragraphs on this page were read as reproduced in Accounting Standards Update 2016-15 (August 2016). The financing inflows paragraph (45-14) was not opened; the SEC staff resource is cited for it.
• This page follows US GAAP. IFRS has its own classification rules in IAS 7, including for interest and dividends, which are not covered here.