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CFA Level I Exam · Analyzing Statements of Cash Flows I

How to Prepare a Cash Flow Statement and Convert Indirect to Direct

Updated 7 October 2026 · Fact-checked

To prepare a cash flow statement, build CFO, CFI and CFF from income statement items and balance sheet changes, then add them to get the net change in cash. To convert indirect CFO to direct, start with each income statement line and adjust it for the related working capital change.

Understand Converting Between Methods and Preparing the Statement

A cash flow statement turns accrual accounting back into cash. The income statement records revenue when earned and expenses when incurred. The balance sheet shows what is still unpaid or unreceived. The difference between the two is the change in working capital accounts.

The direct method lists actual cash receipts and payments: cash collected from customers, cash paid to suppliers, cash paid to employees, interest paid and taxes paid. The indirect method starts with net income and adjusts for non-cash items and working capital changes. Both give the same CFO. Only the presentation differs.

To convert, take each income statement line and ask which balance sheet account sits between it and cash. Sales sit behind accounts receivable. Cost of goods sold sits behind inventory and accounts payable. Operating expenses sit behind prepaid and accrued items. Income tax expense sits behind taxes payable and deferred taxes. An asset that rises ties up cash. A liability that rises keeps cash in the firm.

To prepare the full statement, work through the balance sheet account by account. Fixed asset changes give investing flows. Debt and equity changes, plus dividends from retained earnings, give financing flows. Non-cash items, such as depreciation or gains on sale, are removed from CFO. Gains and losses on asset sales move to investing, where only the cash proceeds appear.

Finally, CFO + CFI + CFF (+ any currency effect on cash) is the net change in cash. Add it to beginning cash. The result must equal ending cash on the balance sheet. That check catches most errors.

Key formulas to remember

Cash collected from customers
Revenue − increase in accounts receivable + increase in unearned revenue
Reverse the signs for a decrease. Assumes no bad debt write-offs unless the question gives them.
Purchases
COGS + ending inventory − beginning inventory
Use this first, then adjust for accounts payable.
Cash paid to suppliers
Purchases − increase in accounts payable
Equivalent: COGS + increase in inventory − increase in accounts payable.
Cash paid for operating expenses
Operating expense + increase in prepaid − increase in accrued liabilities
Exclude depreciation and amortization because they are non-cash.
Cash taxes paid
Income tax expense − increase in taxes payable − increase in deferred tax liability + increase in deferred tax asset
If there are no deferred taxes, use only the change in taxes payable.
Book value of an asset sold
Cost − accumulated depreciation; sale proceeds = book value + gain (or − loss)
Proceeds go in CFI. Remove the gain or loss from CFO in the indirect method.
Capital expenditure from net PP&E
Ending net PP&E − beginning net PP&E + depreciation + book value of assets sold
Assumes no revaluation, impairment or non-cash acquisitions.
Dividends paid
Beginning retained earnings + net income − ending retained earnings
Assumes no other changes to retained earnings.
Net change in cash
CFO + CFI + CFF (+ effect of exchange rates on cash) = ending cash − beginning cash
Use this as the final reconciliation.

How to solve Converting Between Methods and Preparing the Statement questions

Use the same routine for conversion questions and for full statement questions. Work one line at a time and keep a running total.

  1. 1Decide what is asked: one direct-method line, total CFO, or the whole statement.
  2. 2List every balance sheet change and mark each as an increase or decrease, and as an asset or liability.
  3. 3For each operating line, start from the income statement figure and adjust for its linked working capital account. Asset up means cash down. Liability up means cash up.
  4. 4Remove non-cash items such as depreciation, amortization and gains or losses on sales from operating figures.
  5. 5Derive investing flows from fixed asset and investment accounts. Derive financing flows from debt, share capital and dividends.
  6. 6Classify interest and dividends using the stated standard. Under IFRS, interest and dividends received are operating or investing, and interest and dividends paid are operating or financing, applied consistently. Under US GAAP, interest paid, interest received and dividends received are operating, and dividends paid is financing.
  7. 7Add CFO, CFI and CFF, then add to beginning cash and compare with ending cash.
  8. 8If the total does not reconcile, recheck signs on working capital changes first.

Quickest way: Sign-rule shortcut for conversion

When to use it: Use when you are given an income statement and balance sheet changes and need a single CFO or direct-method line quickly.

  1. Write the income statement figure.
  2. For a related asset, subtract the increase or add the decrease.
  3. For a related liability, add the increase or subtract the decrease.
  4. For CFO from net income, add back depreciation and any loss, subtract any gain, then apply the same working capital rule to each account.
  5. Cross-check by computing CFO both ways only if time allows. If the question gives two routes, one check is enough.

Common mistakes in Converting Between Methods and Preparing the Statement

  • Flipping the sign on a working capital change.

    Candidates memorize 'increase means add' without noting whether the account is an asset or a liability.

    Fix: Ask whether the change ties up cash. A rise in receivables or inventory uses cash. A rise in payables or accruals saves cash.

  • Using COGS as cash paid to suppliers.

    COGS looks like the payment to suppliers, but it ignores inventory and payables.

    Fix: Compute purchases first, then adjust for the change in accounts payable.

  • Leaving the gain on sale in CFO and the full proceeds in CFI.

    Candidates forget the gain is already inside net income.

    Fix: Subtract the gain from net income in the indirect method. Show only cash proceeds in CFI.

  • Including depreciation in cash operating expenses.

    Operating expenses on the income statement are taken as a single figure.

    Fix: Strip out depreciation and amortization before adjusting for prepaid and accrued items.

  • Classifying interest and dividends the same way under every standard.

    The IFRS and US GAAP rules differ and are easy to blur.

    Fix: Check which standard the question states. Under US GAAP, interest paid is operating and dividends paid is financing. Under IFRS, you have a choice, so follow the stem.

  • Skipping the cash reconciliation.

    Candidates stop after totaling the three sections.

    Fix: Add the net change to beginning cash and compare with ending cash. A mismatch shows an error.

Worked examples

Example 1

A company reports (USD millions): revenue 1,200; COGS 720; operating expenses excluding depreciation 210; depreciation 60; interest expense 20; income tax expense 60. Accounts receivable rose from 150 to 180. Inventory fell from 100 to 90. Accounts payable rose from 80 to 95. Accrued operating liabilities fell from 20 to 15. Income taxes payable rose from 12 to 18. Interest paid equals interest expense. What is CFO under the direct method? A) 174 B) 186 C) 196

Show the solution
  1. Cash from customers = 1,200 − 30 (rise in receivables) = 1,170.
  2. Purchases = 720 + (90 − 100) = 710. Cash paid to suppliers = 710 − 15 (rise in payables) = 695.
  3. Cash operating expenses = 210 + 5 (fall in accrued liabilities means more paid) = 215.
  4. Interest paid = 20.
  5. Taxes paid = 60 − 6 (rise in taxes payable) = 54.
  6. CFO = 1,170 − 695 − 215 − 20 − 54 = 186.
  7. Check with indirect: net income = 1,200 − 720 − 210 − 60 − 20 − 60 = 130. Add depreciation 60 = 190. Less 30, plus 10, plus 15, less 5, plus 6 = 186.

Answer: B) 186. Option A comes from treating the rise in taxes payable as a use of cash. Option C comes from treating the fall in accrued liabilities as a source of cash.

Example 2

A company starts the year with cash of USD 80 million. CFO is USD 120 million. Net PP&E rose from 500 to 560 after depreciation of 60. Equipment with a book value of 40 was sold for cash of 55. The company borrowed 100 in new long-term debt, and long-term debt rose from 300 to 350. Common stock rose from 200 to 230 through a cash issue. Retained earnings rose from 400 to 440, with net income of 90. What is ending cash? A) 70 B) 125 C) 175

Show the solution
  1. Capital expenditure = 560 − 500 + 60 + 40 = 160.
  2. CFI = −160 + 55 = −105. The gain of 15 is not in CFI. It was already removed from CFO.
  3. Debt repaid = 300 + 100 − 350 = 50.
  4. Dividends paid = 400 + 90 − 440 = 50.
  5. CFF = +100 − 50 + 30 − 50 = +30.
  6. Net change in cash = 120 − 105 + 30 = +45.
  7. Ending cash = 80 + 45 = 125.

Answer: B) 125. Option A ignores the sale proceeds of 55. Option C ignores the dividends of 50.

Exam tips

  • Expect items that give you balance sheet changes and ask for one direct-method line. Identify which account sits behind the line, then apply the sign rule.
  • Read the stem for the standard. Questions on interest and dividend classification depend on whether they say IFRS or US GAAP.
  • Watch for gains, losses and non-cash items. They are usually the distractor that separates the correct option from the second-best one.
  • With three options and no penalty, a quick sign check can eliminate two. If CFO should be lower than net income because receivables rose, remove any option above it.
  • Always do the final cash reconciliation on full-statement questions. It takes seconds and confirms your answer.

Practice questions from Analyzing Statements of Cash Flows I

Converting Between Methods and Preparing the Statement in other exams

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

Converting Between Methods and Preparing the Statement: frequently asked questions

How do I convert indirect-method CFO to the direct method?

Rebuild each income statement line as cash. Adjust revenue for the change in receivables, COGS for inventory and payables, and expenses for prepaid and accrued items. Strip out depreciation and gains or losses. The total must equal the indirect CFO.

Why does a gain on the sale of equipment not appear in CFO?

The gain is in net income, but the cash from the sale is an investing inflow. Under the indirect method you subtract the gain from net income. The full proceeds then appear in CFI.

How do I reconcile the net change in cash?

Add CFO, CFI and CFF, plus any effect of exchange rates on cash. Add the result to beginning cash. It must match ending cash on the balance sheet.

Does the direct method change the total CFO?

No. Both methods give the same CFO. They differ only in presentation, since the direct method shows receipts and payments and the indirect method starts with net income.