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Business Finance · Construction and features of company accounts and reports

Cash Flow Statement: Direct and Indirect Method Explained

Updated 11 October 2026 · Fact-checked

A cash flow statement shows the cash a company received and paid in a period, split into operating, investing and financing activities. The indirect method starts from profit before tax and adjusts for non-cash items and working capital changes. The direct method lists actual cash receipts and payments. Both give the same operating cash flow.

Understand Cash Flow Statement

Profit is not cash. Accounts record income when it is earned and costs when they are incurred (the accruals basis). Cash moves at a different time. A company can show a profit and still run out of cash. The cash flow statement shows what actually happened to cash.

The statement splits cash flows into three groups. Operating activities are the main revenue-producing activities: cash from customers, cash paid to suppliers and employees, and tax paid. Investing activities cover buying and selling non-current assets and investments, and interest or dividends received if your syllabus treatment places them here. Financing activities cover raising or repaying share capital and borrowings, and dividends paid.

You can present operating cash flow two ways. The direct method shows gross receipts and payments. The indirect method starts with profit and reconciles it to cash. The indirect method is far more common in practice and in exams, because it uses figures you already have in the statement of profit or loss and the balance sheets.

Why does profit differ from operating cash flow? Three reasons. Non-cash charges such as depreciation reduce profit but use no cash. Gains or losses on disposal of assets belong to investing, not operating. Changes in working capital (inventory, receivables, payables) mean sales and purchases are not paid or received in the same period.

The final check is simple. Net increase or decrease in cash and cash equivalents must equal the change between opening and closing cash on the balance sheets. If it does not, something is missing or has the wrong sign.

Placement of interest and dividends received or paid can vary by accounting framework. Follow the instruction in the question and keep your choice consistent.

Key rules to remember

Indirect method: cash from operations
Profit before tax + depreciation and amortisation + finance costs − investment income ± loss/gain on disposal − increase in inventory − increase in receivables + increase in payables = cash generated from operations
Add back non-cash and non-operating items. Remove investment income and finance costs if they are shown in other sections.
Net cash from operating activities
Cash generated from operations − tax paid (− interest paid, if classed as operating)
Tax paid is not the tax charge. Work it out from the tax account.
Working capital rule
Increase in an asset = cash outflow; increase in a liability = cash inflow
Reverse the sign for decreases.
Tax paid
Opening tax liability + tax charge for the year − closing tax liability
Use the same method for interest paid and dividends paid.
Fixed asset purchases
Closing net book value − opening net book value + depreciation + net book value of disposals
Gives the cost of additions, assuming no revaluations.
Direct method: receipts from customers
Revenue − increase in receivables (or + decrease in receivables)
Payments to suppliers use the same logic with purchases and payables.
Cash reconciliation
Net change in cash = operating + investing + financing flows = closing cash − opening cash
Always use this as your final check.

How to solve Cash Flow Statement questions

Use the same order for every cash flow question. It stops you missing items and makes the working easy to follow.

  1. 1Read the question for the method required (direct or indirect), the classification of interest and dividends, and the definition of cash and cash equivalents.
  2. 2Set up the three headings: operating, investing, financing. Leave space for the net change and the opening and closing cash reconciliation.
  3. 3For the indirect method, start with profit before tax. Add back depreciation and finance costs, deduct investment income, and adjust for any gain or loss on disposal.
  4. 4Work out the changes in inventory, receivables and payables from the two balance sheets. Apply the sign rule: asset up means cash down, liability up means cash up.
  5. 5Calculate tax paid, interest paid, dividends paid and asset purchases or sales using opening balance, movement and closing balance workings. Show each working.
  6. 6Fill in investing flows (asset purchases and sales, investment income) and financing flows (shares issued, loans raised or repaid, dividends paid).
  7. 7Add the three sections to get the net change in cash. Compare with the change in cash on the balance sheets. Investigate any difference.
  8. 8Add a one-line comment if asked, for example on whether operating cash covers capital expenditure and dividends.

Quickest way: Balance sheet movement shortcut

When to use it: Use when you have two balance sheets and a profit figure, and time is short on a multiple-choice or short written question.

  1. Write down profit before tax, then add depreciation and finance costs straight away.
  2. Scan each current asset and liability: compute the change and apply the sign rule in one line.
  3. Subtract tax paid, using opening liability + charge − closing liability.
  4. Check the total against the cash movement. If it matches, stop; if not, look for a missed disposal, dividend or share issue.
  5. For MCQs, test the sign of your answer first. A growing receivables balance should reduce operating cash flow.

Common mistakes in Cash Flow Statement

  • Adding an increase in receivables or inventory instead of subtracting it

    Students link an increase with a plus sign, but a bigger asset means cash is tied up.

    Fix: Say it aloud: asset up, cash down; liability up, cash up. Check every working capital line against this.

  • Using the tax charge from the profit statement instead of tax paid

    The charge is the easiest number to find.

    Fix: Build a small tax account: opening liability + charge − closing liability = tax paid.

  • Forgetting to add back depreciation, or adding it back twice

    Depreciation can appear in both the profit statement and the fixed asset note.

    Fix: Add it back once, in the reconciliation from profit. Use it in the asset working only to find the cost of additions.

  • Leaving gains or losses on disposal in operating flows

    They are inside profit, so students forget they are not operating cash.

    Fix: Reverse the gain or loss in the reconciliation and show the full sale proceeds under investing.

  • Treating dividends declared as dividends paid

    Proposed dividends appear in the notes and are easy to pick up.

    Fix: Use opening retained earnings + profit after tax − dividends = closing retained earnings, or the dividend payable account, to find cash paid.

  • Confusing the direct and indirect methods

    Both give the same operating cash flow, so students mix up the layout.

    Fix: Direct lists receipts and payments. Indirect starts with profit and adjusts. Only the operating section differs; investing and financing are identical.

Worked examples

Example 1

A company reports profit before tax of ₹8,00,000 for the year. Depreciation was ₹2,00,000 and finance costs were ₹50,000. Inventory rose by ₹1,00,000, receivables rose by ₹1,50,000 and payables rose by ₹60,000. Tax paid was ₹1,60,000 and interest paid was ₹50,000. Using the indirect method, find net cash from operating activities, with interest paid shown as an operating flow.

Show the solution
  1. Start with profit before tax: ₹8,00,000.
  2. Add back depreciation: 8,00,000 + 2,00,000 = ₹10,00,000.
  3. Add back finance costs, because interest paid is shown separately: 10,00,000 + 50,000 = ₹10,50,000.
  4. Increase in inventory is a cash outflow: 10,50,000 − 1,00,000 = ₹9,50,000.
  5. Increase in receivables is a cash outflow: 9,50,000 − 1,50,000 = ₹8,00,000.
  6. Increase in payables is a cash inflow: 8,00,000 + 60,000 = ₹8,60,000. This is cash generated from operations.
  7. Deduct interest paid: 8,60,000 − 50,000 = ₹8,10,000.
  8. Deduct tax paid: 8,10,000 − 1,60,000 = ₹6,50,000.

Answer: Net cash from operating activities = ₹6,50,000.

Example 2

For a company, opening and closing figures are: net book value of plant ₹10,00,000 and ₹12,00,000; opening tax liability ₹70,000 and closing ₹90,000; tax charge for the year ₹1,40,000. Depreciation for the year was ₹1,50,000. Plant with a net book value of ₹60,000 was sold for ₹80,000. New shares of ₹3,00,000 were issued and a loan of ₹2,00,000 was repaid. Dividends paid were ₹1,00,000. Find tax paid, the cost of plant purchased, and net cash from investing and financing activities.

Show the solution
  1. Tax paid = opening liability + charge − closing liability = 70,000 + 1,40,000 − 90,000 = ₹1,20,000.
  2. Plant purchased = closing NBV − opening NBV + depreciation + NBV of disposals = 12,00,000 − 10,00,000 + 1,50,000 + 60,000 = ₹4,10,000.
  3. Check: 10,00,000 + 4,10,000 − 1,50,000 − 60,000 = 12,00,000. This agrees.
  4. Investing: purchase of plant −4,10,000; sale proceeds +80,000. Net investing = −₹3,30,000.
  5. Financing: shares issued +3,00,000; loan repaid −2,00,000; dividends paid −1,00,000. Net financing = 0.
  6. The gain on disposal is 80,000 − 60,000 = ₹20,000. It must be deducted in the operating reconciliation, and the full ₹80,000 shown in investing.

Answer: Tax paid = ₹1,20,000; plant purchased = ₹4,10,000; net investing cash flow = −₹3,30,000; net financing cash flow = ₹0.

Exam tips

  • Show every working for tax paid, asset additions and dividends. Method marks are given even if one figure is wrong.
  • Read the question for where interest and dividends should appear. State your choice in a line so the marker can follow it.
  • In MCQs, check signs first. Many wrong options differ from the correct one only by the direction of a working capital item.
  • For written questions on interpretation, link cash flow to profit: explain why profit and operating cash flow differ, using depreciation and working capital changes.
  • Always finish with the cash reconciliation. A matching total is the quickest proof that the statement is right.

Practice questions from Construction and features of company accounts and reports

Cash Flow Statement in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cash Flow Statement: frequently asked questions

What is the difference between the direct and indirect method of cash flow?

The direct method shows gross cash receipts from customers and gross payments to suppliers and employees. The indirect method starts with profit and adjusts for non-cash items and working capital changes. Both give the same net cash from operating activities. Investing and financing sections are the same.

Why does profit differ from operating cash flow?

Profit is based on accruals, cash flow is not. Depreciation reduces profit but not cash. Credit sales raise profit before cash is received, and credit purchases lower profit before cash is paid. Changes in inventory, receivables and payables explain most of the gap.

How do I prepare a cash flow statement using the indirect method?

Start with profit before tax. Add back depreciation and finance costs, and remove gains or losses on disposal and investment income. Adjust for changes in inventory, receivables and payables. Then deduct tax paid. Add investing and financing flows and reconcile to the change in cash.

Is depreciation a source of cash?

No. Depreciation is a non-cash expense. You add it back only because it was deducted in reaching profit. Adding it back cancels that deduction and does not create cash.