CFA Level I Exam · Analyzing Statements of Cash Flows I

Direct vs Indirect Method of the Cash Flow Statement

Updated 7 October 2026 · Fact-checked

Both methods give the same cash flow from operations (CFO). The direct method lists cash received from customers and cash paid to suppliers, employees and others. The indirect method starts with net income and adjusts for non-cash items and working capital changes. Solve questions by tracking each balance sheet change to its cash effect.

Understand Direct vs Indirect Method of Cash Flow Statement

The cash flow statement explains why cash changed during a period. Operating cash flow (CFO) can be shown in two ways. The total is identical. Only the presentation differs.

The direct method shows operating cash flows by source: cash collected from customers, cash paid to suppliers, cash paid to employees, and cash paid for interest and taxes. It reads like a cash version of the income statement.

Classification of interest and dividends affects what appears in CFO. Under IFRS, interest and dividends paid may be classified in CFO or CFF, and interest and dividends received may be classified in CFO or CFI. So interest paid is not always in CFO under IFRS. Under US GAAP, interest paid and interest received are in CFO. If a company classifies an item outside CFO, it does not appear in the operating section.

The indirect method starts with net income and works back to cash. You add back non-cash charges such as depreciation and amortisation. You remove gains and losses that belong to investing or financing, such as a gain on sale of equipment. Then you adjust for changes in operating working capital, because accrual accounting records revenue and expense at a different time from cash.

The working capital logic is simple. If an operating asset rises (receivables, inventory), cash was tied up, so CFO falls. If an operating liability rises (payables, accrued expenses), you delayed paying cash, so CFO rises. Reverse each when the balance falls.

Under IFRS and US GAAP, both methods are allowed. Both standard setters encourage the direct method, but most companies use the indirect method. Preparing it from existing accrual records is generally cited as one reason. Under US GAAP, a company using the direct method must also give the indirect reconciliation. Analysts often like the direct method because it shows the components of cash flow. The indirect method shows why net income and CFO differ.

Key formulas to remember

Cash received from customers: Revenue − increase in accounts receivable (or + decrease in accounts receivable); If unearned revenue changes, add an increase and subtract a decrease.
Cash paid to suppliers: Cash paid to suppliers = Purchases − increase in accounts payable (or + decrease in accounts payable); Purchases = COGS + increase in inventory (or − decrease in inventory); Do the inventory step first to get purchases, then the payables step.
Cash paid to employees: Cash paid to employees = Salary expense + decrease in salaries payable (or − increase in salaries payable); The same logic applies to other operating expenses. For prepaid expenses, add an increase in prepaids and subtract a decrease.
Indirect CFO: CFO = Net income + non-cash charges − non-operating gains + non-operating losses − increase in operating assets + decrease in operating assets + increase in operating liabilities − decrease in operating liabilities; Non-cash charges include depreciation, amortisation and impairment. Gains and losses on asset sales are removed because the cash goes to CFI.
Direct and indirect equivalence: CFO (direct) = CFO (indirect); If your two answers differ, find the error. They cannot differ.

How to solve Direct vs Indirect Method of Cash Flow Statement questions

Use this method for any question that asks you to build or compare operating cash flow under the two methods.

1Decide which method the question asks for, or whether it asks you to convert one into the other.
2List the income statement items you need: revenue, COGS, operating expenses, depreciation, gains or losses, taxes.
3List the opening and closing balances of operating working capital accounts and find each change.
4For the direct method, take each income statement line and adjust it for the related balance sheet change to get cash.
5For the indirect method, start at net income, add back non-cash items, remove non-operating gains and add back losses.
6Apply the rule: operating asset up means cash down; operating liability up means cash up.
7Check the sign of every adjustment, then total the figures.
8If both methods are possible, compute one as a cross-check if time allows.

Quickest way: Asset up, cash down; liability up, cash up

When to use it: Use this for indirect-method conversions when you are given balance sheet changes and net income, and you only need the CFO total.

Write net income.
Add depreciation and amortisation.
Subtract gains and add losses on asset sales.
For each working capital account, ask: did the asset rise or did the liability fall? If yes, subtract the change. Otherwise add it.
Add up. Do not rebuild the whole statement.
Do not touch debt, equity, fixed assets or dividends. They belong to CFI or CFF.

Common mistakes in Direct vs Indirect Method of Cash Flow Statement

Adding an increase in receivables to net income.
Students confuse the sign with the liability rule, or think a bigger balance means more cash.
Fix: A bigger receivable means sales not yet collected. Subtract it. Memorise: operating asset up, cash down.
Forgetting to remove a gain on sale of equipment in the indirect method.
The gain sits inside net income and looks like part of operations.
Fix: Subtract the gain from net income. The full sale proceeds appear in CFI.
Using COGS as cash paid to suppliers.
Students skip the inventory and payables adjustments.
Fix: First compute purchases = COGS + increase in inventory. Then adjust for the change in payables.
Adding back depreciation in the direct method.
Depreciation add-back is a habit from the indirect method.
Fix: The direct method never includes depreciation, because it is not a cash payment. Just leave it out.
Including debt or dividend balance changes in CFO.
Students adjust every balance sheet account.
Fix: Only operating working capital accounts adjust CFO. Borrowings and dividends belong to financing.
Assuming the two methods give different CFO.
The layouts look different.
Fix: Total CFO is always the same. Only the presentation changes.

Worked examples

Example 1

A company reports revenue of $900,000, cost of goods sold of $540,000, and net income of $120,000. Accounts receivable rose from $80,000 to $95,000. Inventory fell from $60,000 to $50,000. Accounts payable rose from $40,000 to $48,000. Under the direct method, cash paid to suppliers is closest to:
A) $522,000
B) $538,000
C) $542,000

Show the solution

Purchases = COGS + increase in inventory. Inventory fell by $10,000, so purchases = $540,000 − $10,000 = $530,000.
Payables rose by $8,000, so some purchases were not paid in cash.
Cash paid to suppliers = $530,000 − $8,000 = $522,000.
Check the traps: each wrong option comes from one sign error. $542,000 adds the inventory fall instead of subtracting it ($550,000), then correctly subtracts payables ($550,000 − $8,000). $538,000 gets purchases right ($530,000) but adds the payables increase instead of subtracting it. Only $522,000 applies both rules correctly.

Answer: A) $522,000

Example 2

A company reports net income of $200,000, depreciation of $30,000 and a gain on sale of equipment of $12,000. Accounts receivable increased by $18,000, inventory decreased by $9,000, and accounts payable increased by $6,000. Cash flow from operations using the indirect method is closest to:
A) $200,000
B) $215,000
C) $221,000

Show the solution

Start with net income: $200,000.
Add depreciation, a non-cash charge: $200,000 + $30,000 = $230,000.
Subtract the gain on sale, which belongs in CFI: $230,000 − $12,000 = $218,000.
Receivables rose by $18,000, so subtract: $218,000 − $18,000 = $200,000.
Inventory fell by $9,000, so add: $200,000 + $9,000 = $209,000.
Payables rose by $6,000, so add: $209,000 + $6,000 = $215,000.

Answer: B) $215,000

Exam tips

Questions are standalone with three options, so test each distractor by flipping one sign. Wrong options are usually built from one sign error.
Always ask whether an account is operating or not. Debt, equity and fixed assets rarely adjust CFO.
Numerical options are listed smallest to largest, so check whether your answer sits at the edge of the range. Sign errors often push you to an extreme.
Know the conceptual points: both methods give the same CFO, and the indirect method is more common in practice.
A TI BA II Plus is not needed for this topic. Use the calculator memory only for chained additions if you want to avoid arithmetic slips.

Practice questions from Analyzing Statements of Cash Flows I

Direct vs Indirect Method of 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.

Direct vs Indirect Method of Cash Flow Statement: frequently asked questions

What is the main difference between the direct and indirect method?

The direct method shows operating cash receipts and payments by category. The indirect method starts with net income and adjusts it to CFO. Both produce the same total CFO.

Why is depreciation added back in the indirect method?

Depreciation reduces net income but involves no cash outflow in the period. Adding it back removes that non-cash deduction so the result reflects cash.

How do I calculate cash received from customers?

Start with revenue. Subtract any increase in accounts receivable, or add a decrease. If unearned revenue rose, add that increase because cash arrived before revenue was recognised.

Which method do most companies use?

Most companies report using the indirect method. Preparing it from existing accrual records is generally cited as one reason. Standard setters allow both and encourage the direct method.