The Cash Flow Statement and Financial Ratios | Free Bookkeeping & Accounting Course

What you'll learn

How the cash flow statement sorts cash into operating, investing and financing activities.
How to prepare it with the direct and the indirect method.
How to calculate liquidity, leverage and profitability ratios, plus the debt coverage ratio lenders love.
How to read ratios over time and against your industry.
A monthly checklist to review your business's numbers.

📥 Practice this lesson

The template calculates net margin, current ratio, debt ratio and working capital from your journal.

bookkeeping-template.xlsx · Financial Statements sheet, Ratios section

This lesson completes the set of financial statements. The statement of cash flows explains why a business with a profit can still run out of money, and financial ratios turn the three statements into a quick health check you can run on any company in minutes.

The statement of cash flows

This statement shows the actual cash that came in and went out during a period, sorted into three activities:

Activity	What it includes	Healthy sign
Operating	Cash from customers; payments to suppliers, employees and landlords; interest and income taxes paid	Positive: the business generates cash on its own.
Investing	Buying or selling equipment, vehicles, property, other businesses	Usually negative in a growing business that's investing.
Financing	Owner contributions, loans received, loan principal repaid, owner draws or dividends	Depends on the stage: positive when starting, negative when paying down debt or paying owners.

A U.S. detail worth knowing: under GAAP, interest paid counts as an operating cash flow, even though the loan itself is financing. (IFRS lets companies choose.) Owner draws and dividends paid are financing.

Brightside's cash flow (direct method)

Brightside Coffee LLC · Month 1	Amount
Cash received from customers	$18,000
Rent paid	($3,500)
Wages paid	($7,000)
Payments to suppliers	$0
Net cash from operating activities	$7,500
Purchase of espresso equipment	($12,000)
Net cash used in investing activities	($12,000)
Owner contribution	$40,000
Bank loan received	$10,000
Net cash from financing activities	$50,000
Net increase in cash	$45,500
Cash at beginning of month	$0
Cash at end of month	$45,500

Brightside's cash flows by activity (green = cash in, red = cash out)

Operating+$7,500

Investing−$12,000

Financing+$50,000

Net income was $2,300, but operating cash flow was $7,500. Why? Depreciation ($200) used no cash, and above all, the $6,000 of supplies were bought on credit and haven't been paid yet. When Brightside pays that bill next month, cash will drop even though profit won't change.

The indirect method: from profit to cash

Most companies, and most accounting software, present operating cash flow by starting with net income and adjusting it:

  Net income                                        $2,300
+ Depreciation (an expense that used no cash)         $200
+ Increase in accounts payable (not paid yet)       $6,000
− Increase in inventory (cash tied up on shelves)  ($1,000)
= Net cash from operating activities                $7,500

The logic: an increase in a current asset (receivables, inventory, prepaid expenses) absorbs cash; an increase in a current liability (payables, accrued wages, unearned revenue) frees cash. It's the cash conversion cycle from lesson 9, expressed in dollars.

Look forward, not just back: the 13-week cash forecast

A historical cash flow statement tells you what happened. Even more useful is projecting cash week by week for the next 13 weeks: starting balance + expected collections − committed payments (payroll, rent, loan payments, sales tax, estimated taxes). If any week goes negative, you see it a quarter in advance, with time to collect faster, delay a purchase or line up credit.

1. Brightside buys a delivery van for catering. Which section of the cash flow statement does the purchase go in?

Operating
Investing
Financing

Buying or selling long-term assets is an investing activity. If a bank financed the van, the loan proceeds would appear under financing.

Financial ratios: a checkup for the business

Ratios relate figures from the statements to answer specific questions. They fall into three families:

Liquidity

Can the business pay what's due in the next year?

Current ratio, quick ratio, working capital

Leverage

How much depends on borrowed money, and can it service the debt?

Debt ratio, debt-to-equity, DSCR

Profitability

How much does it earn on sales, on assets and on the owner's money?

Margins, ROA, ROE

Liquidity

Ratio	Formula	Brightside	Rough guide
Current ratio	Current assets ÷ Current liabilities	$46,500 ÷ $11,000 = 4.23	1.2 to 2 is usually comfortable
Quick (acid-test) ratio	(Current assets − Inventory) ÷ Current liabilities	$45,500 ÷ $11,000 = 4.14	Around 1 or higher

A current ratio of 4.2 means Brightside is sitting on a lot of idle cash, fresh from Maya's investment and the loan. It's safe, but money sitting in a checking account earns almost nothing.

Leverage

Ratio	Formula	Brightside
Debt ratio	Total liabilities ÷ Total assets	$16,000 ÷ $58,300 = 27.4%
Debt-to-equity	Total liabilities ÷ Total equity	$16,000 ÷ $42,300 = 0.38
Debt service coverage (DSCR)	Cash-based operating earnings ÷ Loan payments (principal + interest)	($2,300 + $200) ÷ $450 = 5.6

The DSCR is the ratio U.S. banks and SBA lenders care about most for small businesses: can your earnings cover your loan payments? Here we use operating income plus depreciation as a simple measure of cash earnings against the $450 monthly loan payment that starts next month. A DSCR below 1 means the payments can't be covered from operations; many lenders want to see 1.25 or more.

Profitability

Ratio	Formula	Brightside (month)
Gross margin	Gross profit ÷ Sales	$13,000 ÷ $18,000 = 72.2%
Operating margin	Operating income ÷ Sales	$2,300 ÷ $18,000 = 12.8%
Net margin	Net income ÷ Sales	$2,300 ÷ $18,000 = 12.8%
Return on assets (ROA)	Net income ÷ Total assets	$2,300 ÷ $58,300 = 3.9%
Return on equity (ROE)	Net income ÷ Owner's equity	$2,300 ÷ $42,300 = 5.4%

ROE is the owner's question: for every dollar I put in, how much does the business earn? 5.4% in one month looks spectacular, but be careful: it's a single opening month, before loan interest and before any pay for Maya's 60-hour weeks. Track it over a full year before drawing conclusions.

How to use ratios well

A ratio on its own says little. Compare it with the same ratio in earlier periods (the trend) and with businesses in your industry: a grocery store and a software company have completely different margins. The "rough guide" values above are just starting points, and industry benchmark data from trade associations or your bank is worth asking for.

2. A company's current ratio is 0.8. What does that tell you?

It has strong liquidity
Its current assets don't cover its short-term debts
It's profitable

Current ratio = current assets ÷ current liabilities. Below 1, debts due within a year exceed what can be turned into cash in that time.

3. Net income is $96,000 on sales of $1,200,000. What is the net margin?

8%
12.5%
80%

$96,000 ÷ $1,200,000 = 0.08 = 8%. Out of every $100 of sales, $8 is profit.

4. Using the indirect method, how does a $5,000 increase in accounts receivable affect operating cash flow?

It adds $5,000
It has no effect, because it isn't cash
It subtracts $5,000, because sales were recorded but the cash wasn't collected

Revenue in net income includes credit sales not yet collected. The increase in receivables is subtracted to get back to actual cash.

Your monthly numbers review

Did sales rise or fall versus last month and the same month last year?
Is the gross margin holding? If not, check supplier prices, waste and discounts.
How far above break-even am I?
Is operating cash flow positive?
What does my 13-week cash forecast show, including tax payments?
Are customers paying on time, and is inventory turning?
Is debt growing faster than sales?

Practice exercise: diagnose an online store

Lakeside Home Co., an online home goods store in Minneapolis organized as a C corporation, reports for the year: sales $1,200,000; COGS $720,000; operating expenses $330,000 (including $30,000 of depreciation); interest $20,000; income tax expense $33,800. Year-end balance sheet: current assets $400,000 (including $180,000 of inventory), total assets $600,000, current liabilities $250,000, total liabilities $350,000. During the year, receivables rose $40,000, inventory rose $60,000 and payables rose $20,000.

Calculate net income, gross margin and net margin.
Calculate the current ratio, quick ratio and debt ratio.
Calculate ROE.
Calculate operating cash flow with the indirect method.
Write a three-line diagnosis.

See solution

Gross profit     = $1,200,000 − $720,000 = $480,000  → gross margin 40.0%
Operating income = $480,000 − $330,000   = $150,000
Pre-tax income   = $150,000 − $20,000    = $130,000
Net income       = $130,000 − $33,800    =  $96,200  → net margin 8.0%

Current ratio = $400,000 ÷ $250,000                = 1.60
Quick ratio   = ($400,000 − $180,000) ÷ $250,000   = 0.88
Debt ratio    = $350,000 ÷ $600,000                = 58.3%

Equity = $600,000 − $350,000 = $250,000  → ROE = $96,200 ÷ $250,000 = 38.5%

Operating cash flow = $96,200 + $30,000 − $40,000 − $60,000 + $20,000 = $46,200

Diagnosis: profitable with a strong ROE, but it turns less than half its profit into cash ($46,200 vs. $96,200) because money is piling up in inventory and receivables. A quick ratio under 1 means it needs to sell inventory to pay short-term debts. Priorities: turn inventory faster and tighten collections.

Summary

The cash flow statement separates operating, investing and financing activities; under U.S. GAAP, interest paid is operating.
The indirect method starts from net income, adds back non-cash expenses and adjusts for changes in working capital.
Liquidity, leverage and profitability ratios turn statements into answers; compare them over time and with your industry.
Lenders focus on the debt service coverage ratio: can earnings cover the loan payments?
Forecast cash 13 weeks ahead so a tight month never surprises you.

Next lesson: Business Budgeting and Budget vs. Actual Analysis. You'll build Brightside's budget for next quarter, project its cash and compare plan against reality.