Financial Accounting · Statement of cash flows (excluding partnerships)

Cash Generated from Operations: Indirect Method Explained

Updated 11 October 2026 · Fact-checked

The indirect method starts with profit before tax and converts it into cash generated from operations. Add back depreciation, finance costs and losses on disposal. Deduct investment income and profits on disposal. Then adjust for working capital: an increase in inventories or receivables reduces cash, and an increase in payables increases cash.

Understand Cash Generated from Operations: Indirect Method

Profit is not cash. Profit is measured on the accruals basis, so it includes sales not yet collected, costs not yet paid and non-cash items such as depreciation. The statement of cash flows under IAS 7 shows the actual cash movement. The first section, operating activities, begins with cash generated from operations.

There are two ways to show it. The direct method lists cash received from customers and cash paid to suppliers and employees. The indirect method starts with profit before tax and adjusts it until it equals cash. IAS 7 allows both. The indirect method is the one you are examined on most, because you can build it from the statement of profit or loss and two statements of financial position.

The adjustments come in three groups. First, remove non-cash items: depreciation and amortisation are added back because they reduced profit but used no cash. Second, remove items that belong in other sections of the statement: finance costs and investment income go to financing or investing, and profit or loss on disposal is replaced by the full sale proceeds in investing. Third, adjust for working capital changes, because sales and purchases on credit make profit differ from cash.

The working capital logic is simple. If inventories rise, you spent cash on stock that has not yet been expensed, so cash falls. If receivables rise, customers owe you more, so cash falls. If payables rise, you have delayed paying, so cash rises. Reverse each when the balance falls.

The result is cash generated from operations. Interest paid and tax paid are then deducted separately to reach net cash from operating activities.

Key formulas to remember

Start point: Profit before tax (from the statement of profit or loss); Use profit before tax, not profit after tax, because tax paid is deducted later.
Non-cash and reclassified items: + Depreciation and amortisation + Finance costs + Loss on disposal − Profit on disposal − Investment income; Finance costs and investment income are removed here and shown in their own sections. Disposal results are replaced by proceeds in investing.
Inventories: (Increase) or decrease in inventories = opening − closing; A negative answer is a deduction from profit.
Receivables: (Increase) or decrease in receivables = opening − closing; Use trade and other receivables together unless told otherwise.
Payables: Increase or (decrease) in payables = closing − opening; Note the reversed order compared with assets.
Net cash from operations: Cash generated from operations − interest paid − income tax paid; Interest paid may instead be shown under financing if the question says so.

How to solve Cash Generated from Operations: Indirect Method questions

Use the same layout every time. It keeps the signs under control and earns method marks.

1Write the heading 'Cash flows from operating activities' and start with profit before tax.
2Add back depreciation and amortisation charged for the year.
3Add finance costs, deduct investment income, and add a loss or deduct a profit on disposal.
4Compute opening minus closing for inventories and for receivables. Keep the sign you get.
5Compute closing minus opening for payables. Keep the sign you get.
6Total the lines to get cash generated from operations.
7Deduct interest paid and income tax paid, using the ledger workings if the figures are not given directly.
8Sense-check: a rise in assets should lower cash, and a rise in liabilities should raise it.

Quickest way: Asset down, liability up: the sign rule

When to use it: Use it in multiple choice and number entry questions where you only need the final cash figure.

Write profit before tax, then list only the adjustments the question gives.
For each asset (inventory, receivables), a rise is minus and a fall is plus.
For payables, a rise is plus and a fall is minus.
Add back depreciation and finance costs. Deduct any investment income. Add a loss or deduct a profit on disposal.
Add up once, then check you did not use profit after tax or include interest paid or tax paid.

Common mistakes in Cash Generated from Operations: Indirect Method

Adding an increase in receivables to profit.
Students see 'increase' and assume it is good for cash.
Fix: Receivables are an asset. A rise means customers have not yet paid, so deduct it.
Starting from profit after tax.
The question gives several profit figures and the wrong one is picked.
Fix: Start from profit before tax. Tax paid is deducted separately after cash generated from operations.
Adjusting for a profit on disposal in the wrong direction.
Students add everything non-cash without thinking about what the item did to profit.
Fix: A profit increased profit, so deduct it. A loss reduced profit, so add it back. The cash proceeds go to investing activities.
Forgetting to remove finance costs and investment income.
They appear in the statement of profit or loss but not in the working capital section.
Fix: Add back finance costs and deduct investment income, then deal with the cash in the proper section.
Using closing minus opening for all balances.
One formula feels easier to remember.
Fix: Assets are opening minus closing. Payables are closing minus opening. Check the sign by asking whether cash went up or down.
Using the depreciation balance from the statement of financial position.
Accumulated depreciation is confused with the year's charge.
Fix: Add back only the charge for the year. If it is not given, work it out from the non-current assets workings, allowing for disposals.

Worked examples

Example 1

A company reports profit before tax of $240,000. The statement of profit or loss includes depreciation of $45,000, finance costs of $12,000 and a profit on disposal of non-current assets of $8,000. Inventories rose from $60,000 to $75,000, receivables fell from $90,000 to $82,000, and payables rose from $50,000 to $58,000. Calculate cash generated from operations.

Show the solution

Start: profit before tax = $240,000.
Add depreciation: 240,000 + 45,000 = 285,000.
Add finance costs: 285,000 + 12,000 = 297,000.
Deduct profit on disposal: 297,000 − 8,000 = 289,000.
Inventories: opening 60,000 − closing 75,000 = −15,000. Cash falls. 289,000 − 15,000 = 274,000.
Receivables: opening 90,000 − closing 82,000 = +8,000. 274,000 + 8,000 = 282,000.
Payables: closing 58,000 − opening 50,000 = +8,000. 282,000 + 8,000 = 290,000.

Answer: Cash generated from operations is $290,000.

Example 2

A company has profit before tax of $130,000 after charging depreciation of $30,000, finance costs of $5,000 and a loss on disposal of $4,000. It also received investment income of $3,000. Inventories fell from $40,000 to $34,000, receivables rose from $55,000 to $70,000, and payables fell from $38,000 to $31,000. Calculate cash generated from operations.

Show the solution

Start: profit before tax = $130,000.
Add depreciation: 130,000 + 30,000 = 160,000.
Add finance costs: 160,000 + 5,000 = 165,000.
Add loss on disposal: 165,000 + 4,000 = 169,000.
Deduct investment income: 169,000 − 3,000 = 166,000.
Inventories: 40,000 − 34,000 = +6,000. 166,000 + 6,000 = 172,000.
Receivables: 55,000 − 70,000 = −15,000. 172,000 − 15,000 = 157,000.
Payables: closing 31,000 − opening 38,000 = −7,000. 157,000 − 7,000 = 150,000.

Answer: Cash generated from operations is $150,000.

Exam tips

Read whether the question asks for cash generated from operations or net cash from operating activities. The second needs interest and tax paid deducted.
In multiple response questions about adjustments, decide for each item whether it was a non-cash charge, a reclassified item or a working capital movement.
Write the sign next to every working capital figure before you total. Most lost marks are sign errors.
If depreciation is not given, find it from the opening and closing non-current asset balances, additions and disposals before you start the reconciliation.
Where a question compares direct and indirect methods, remember both give the same cash generated from operations. Only the presentation differs.

Practice questions from Statement of cash flows (excluding partnerships)

Cash Generated from Operations: Indirect Method: frequently asked questions

What is the difference between the direct and indirect method?

The direct method shows cash received from customers and cash paid to suppliers and employees. The indirect method starts with profit before tax and adjusts it to cash. Both reach the same figure for cash generated from operations.

Why do we add back depreciation in the cash flow reconciliation?

Depreciation is deducted when calculating profit but involves no cash payment. Adding it back removes that non-cash charge. It is not a source of cash itself.

Why is profit on disposal deducted?

The profit is included in profit before tax but is not an operating cash flow. The actual sale proceeds appear under investing activities, so deducting the profit avoids counting it twice.

Does an increase in payables increase cash?

Yes. It means you bought on credit and have not yet paid, so you kept cash you would otherwise have spent. A decrease in payables reduces cash.