Cash flow statement: the indirect method, worked

What the indirect method is

The indirect method prepares the operating section of a cash flow statement by starting from profit and adjusting it for non-cash items, such as depreciation and gains on disposal, and for changes in working capital, such as receivables, inventory and payables. It matters because it explains why profit and operating cash differ, which is the question lenders and owners ask first.

IAS 7 Statement of Cash Flows requires every IFRS reporter to present a statement of cash flows classified into operating, investing and financing activities. IAS 7 para 18 allows operating cash flows to be reported by either the direct method, which shows gross cash receipts and payments, or the indirect method. IAS 7 para 19 encourages the direct method, yet most companies use the indirect method because it can be prepared from the income statement and two balance sheets. Investing and financing activities are always shown as gross cash flows, whichever method is used for operations.

The three sections and what belongs in each

Classification drives how readers interpret the statement, so get each line in the right section before worrying about arithmetic. Cash here means cash on hand and demand deposits plus cash equivalents: short-term, highly liquid investments readily convertible to known amounts of cash with an insignificant risk of changes in value, typically with a maturity of three months or less from acquisition.

• Operating activities: cash from customers, payments to suppliers and employees, and income tax paid unless specifically identified with investing or financing.
• Investing activities: purchases and sales of property, plant and equipment and intangible assets, acquisitions of businesses, and loans made to others.
• Financing activities: proceeds from issuing shares, borrowing and repaying loans, lease liability principal payments, and dividends paid under most policies.
• Interest and dividends: under current IAS 7 an entity chooses a consistent classification; from 2027 the IFRS 18 amendments fix it for most companies (see below).
• Non-cash transactions, such as acquiring an asset through a lease or converting debt to equity, are excluded from the statement and disclosed instead (IAS 7 para 43).

The worked example: starting figures

A wholesale company reports the following for the year, in EUR. The income statement: revenue 1,200,000; cost of sales 700,000; gross profit 500,000; operating expenses excluding depreciation 250,000; depreciation 60,000; gain on sale of equipment 5,000; operating profit 195,000; interest expense 15,000; profit before tax 180,000; income tax 45,000; profit for the year 135,000.

Balance sheet movements from last year end to this year end: property, plant and equipment 400,000 to 470,000; inventory 90,000 to 110,000; trade receivables 120,000 to 150,000; prepayments 10,000 to 8,000; cash 50,000 to 20,000; trade payables 80,000 to 95,000; accrued expenses 20,000 to 18,000; income tax payable 30,000 to 35,000; bank loan 200,000 to 170,000; share capital 100,000 to 120,000; retained earnings 240,000 to 320,000. Both balance sheets balance: total assets 670,000 last year and 758,000 this year, matched by liabilities and equity.

Additional information: equipment with a net book value of EUR 20,000 was sold for EUR 25,000; new equipment cost EUR 150,000; dividends of EUR 55,000 were declared and paid; all interest was paid in the year.

Step 1: non-cash items

Start from profit before tax and remove everything that affected profit without moving cash, and anything that will be shown elsewhere in the statement. Depreciation reduced profit but used no cash, so add it back. The gain on sale increased profit, but the full sale proceeds will appear in investing activities, so deduct the gain to avoid counting it twice. Interest expense is added back here because the interest actually paid is shown as a separate line.

The result, EUR 250,000, is operating profit before working capital changes. It is close to what analysts call EBITDA, but it is a reconciliation step, not a measure of cash generated.

• Profit before tax: 180,000
• Add depreciation: 60,000
• Deduct gain on sale of equipment: (5,000)
• Add interest expense: 15,000
• Operating profit before working capital changes: 250,000

Step 2: working capital adjustments

Profit records sales when invoiced and costs when incurred. Cash records them when paid. The difference sits in working capital, and one rule handles every line: an increase in an operating asset uses cash and is deducted; a decrease releases cash and is added. For operating liabilities the signs reverse: an increase means cash was kept and is added; a decrease means cash was paid out and is deducted.

Receivables rose by EUR 30,000, meaning customers paid 30,000 less than was invoiced. Inventory rose by EUR 20,000, cash spent on stock not yet sold. Payables rose by EUR 15,000, suppliers financing part of that stock. The net effect of working capital is an outflow of EUR 35,000, so cash generated from operations is EUR 215,000.

• Increase in inventory: (20,000)
• Increase in trade receivables: (30,000)
• Decrease in prepayments: 2,000
• Increase in trade payables: 15,000
• Decrease in accrued expenses: (2,000)
• Net working capital movement: (35,000)
• Cash generated from operations: 250,000 - 35,000 = 215,000

Step 3: interest and tax paid

Interest paid equals the expense of EUR 15,000 because no interest was owed at either year end. Tax paid is found from the tax payable account: opening liability 30,000 plus this year's charge 45,000 minus closing liability 35,000 equals EUR 40,000 paid. Always derive tax and interest paid from the liability accounts in this way; using the income statement charge is one of the most common errors.

Net cash from operating activities is therefore cash generated from operations of 215,000, less interest paid of 15,000 and tax paid of 40,000, which is EUR 160,000. Compare it with profit for the year of EUR 135,000: operations produced more cash than profit, mainly because depreciation was a non-cash charge, even after growth absorbed EUR 35,000 of working capital.

Step 4: investing and financing, and the proof

The property, plant and equipment account explains the investing lines: opening 400,000 plus additions 150,000 minus depreciation 60,000 minus disposals at net book value 20,000 equals the closing 470,000. The disposal brought in EUR 25,000 of cash, the net book value plus the gain. Equity and debt explain the financing lines: shares issued for EUR 20,000, loan repaid EUR 30,000 (200,000 to 170,000) and dividends paid EUR 55,000, which also reconciles retained earnings: 240,000 plus profit 135,000 minus dividends 55,000 equals 320,000.

The proof is that the net change in cash from the statement equals the change in cash on the balance sheet. Operating 160,000, investing minus 125,000 and financing minus 65,000 give a net decrease of EUR 30,000, and cash did fall from EUR 50,000 to EUR 20,000. If the two figures differ, a balance sheet movement has been missed or classified twice.

• Net cash from operating activities: 160,000
• Purchase of property, plant and equipment: (150,000)
• Proceeds from sale of equipment: 25,000
• Net cash used in investing activities: (125,000)
• Proceeds from share issue 20,000, loan repayment (30,000), dividends paid (55,000): net cash used in financing activities (65,000)
• Net decrease in cash: 160,000 - 125,000 - 65,000 = (30,000)
• Cash at beginning of year 50,000; cash at end of year 20,000

The same example by the direct method

The direct method reaches the same cash generated from operations by showing gross flows. Cash received from customers is revenue adjusted for the change in receivables: 1,200,000 minus the 30,000 increase, which is EUR 1,170,000. Cash paid to suppliers and employees starts from cost of sales and operating expenses excluding depreciation, 950,000, then adds the inventory increase of 20,000, deducts the payables increase of 15,000, deducts the prepayments decrease of 2,000 and adds the accruals decrease of 2,000, giving EUR 955,000.

Receipts of 1,170,000 minus payments of 955,000 equal EUR 215,000, the same cash generated from operations as the indirect method. The two methods differ only in presentation; investing, financing and the net change in cash are identical. Many preparers who present the direct method also show the profit-to-operating-cash reconciliation in a note, because readers use it to explain the gap between profit and cash.

What changes with IFRS 18 from 2027

IFRS 18 Presentation and Disclosure in Financial Statements, effective for annual reporting periods beginning on or after 1 January 2027 (as of September 2026), amended IAS 7 in two ways that affect this statement. First, the indirect method must start from operating profit or loss, the new required subtotal, instead of a choice of profit measures. Second, the choices for interest and dividends are removed for most companies: interest paid and dividends paid are classified as financing, and interest and dividends received as investing. Entities with specified main business activities, such as banks, follow different rules.

Applied to the example, the operating section would start from operating profit of EUR 195,000, add depreciation of 60,000 and deduct the gain of 5,000 to reach 250,000, deduct the working capital outflow of 35,000 and tax paid of 40,000, giving net cash from operating activities of EUR 175,000. Interest paid of EUR 15,000 moves to financing, which becomes an outflow of EUR 80,000. The net decrease in cash is unchanged at EUR 30,000: 175,000 minus 125,000 minus 80,000.

Common mistakes and required disclosures

Most errors in cash flow statements come from classification and from treating accounting movements as cash. A final check that the statement reconciles to the change in cash catches arithmetic errors, but not misclassification, so review each line against this list.

• Using the income statement tax or interest charge instead of the amounts actually paid.
• Showing the net book value of a disposal, rather than the proceeds, in investing activities.
• Including non-cash additions, such as right-of-use assets from new leases, as investing outflows.
• Netting new borrowing against repayments instead of showing both gross.
• Treating a bank overdraft as financing when it is repayable on demand and forms an integral part of cash management, in which case IAS 7 para 8 includes it in cash and cash equivalents.
• Leaving out the effect of exchange rate changes on foreign-currency cash, which is shown separately from the three sections.
• Omitting the disclosure of changes in liabilities arising from financing activities required by IAS 7 para 44A, usually given as a reconciliation, which here would show the loan moving from 200,000 to 170,000 through a 30,000 cash repayment.

Preparing the cash flow statement from Skyline Nexus ERP

Skyline Nexus ERP produces a Cash Flow report under Fiscal Authority, Reports, with Operating, Investing and Financing sections, Beginning Cash Balance, Net Change in Cash and Ending Cash Balance, filtered by date range and project. It is built from the movements on accounts flagged as cash or bank, each classified by the Cash Flow Activity set on its account type, which makes it a direct-method analysis of cash movements. It complements the indirect reconciliation from profit, which you build from the ledger reports as described next.

For an indirect-method statement, take the inputs from the ledger reports. The Trial Balance in its Opening / Movement / Closing view gives the movement on every account for the year, including receivables, inventory, payables, tax and loans, and the Balance Sheet and Income Statement can be compared with the previous year. The statements export to Excel, where the reconciliation above can be built and checked against the Net Change in Cash from the Cash Flow report.