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CFA Level I Exam · Analyzing Statements of Cash Flows I

Linking the Cash Flow Statement to the Balance Sheet and Income Statement

Updated 7 October 2026 · Fact-checked

The cash flow statement explains why cash changed. You start with net income, then adjust for non-cash items (depreciation, gains, losses) and changes in working capital, using balance sheet changes. Investing and financing flows come from changes in long-term assets, debt and equity. The result must match the change in cash.

Understand Linking Cash Flow Statement to Balance Sheet and Income Statement

Every cash flow statement is built from the other two statements. The income statement gives net income. The balance sheet gives the opening and closing balance of every account. The change in each balance sheet account is the bridge between them.

Start with the accounting identity: assets = liabilities + equity. Cash is an asset. So any change in cash must satisfy: change in cash = change in liabilities + change in equity − change in non-cash assets. This is why you can rebuild the cash flow statement from two balance sheets and an income statement.

In the indirect method, net income is accrual-based. You convert it to cash. Depreciation and amortization reduced net income but used no cash, so you add them back. A gain on sale of an asset raised net income, but the cash received is the full sale proceeds, which belong in investing. So you subtract the gain in operating cash flow and show the proceeds in investing. A loss on sale is added back for the same reason.

Working capital follows a simple rule. An increase in an operating asset (receivables, inventory) uses cash, so subtract it. A decrease adds cash. An increase in an operating liability (payables, accrued expenses) provides cash, so add it. A decrease uses cash.

Financing items link to debt and equity. New borrowing and share issuance are inflows. Repayments, buybacks and dividends are outflows. Retained earnings tie in: ending retained earnings = opening + net income − dividends declared. If dividends declared differ from dividends paid, the gap sits in dividends payable.

Key formulas to remember

Indirect CFO
CFO = Net income + Depreciation and amortization + Losses − Gains − Increase in operating assets + Decrease in operating assets + Increase in operating liabilities − Decrease in operating liabilities
Use only operating working capital accounts. Exclude cash and debt.
Dividends paid
Dividends paid = Opening retained earnings + Net income − Closing retained earnings
Assumes no other items hit retained earnings and dividends payable is unchanged.
Cash from asset sale
Proceeds = Carrying amount + Gain (or − Loss)
Carrying amount = historical cost − accumulated depreciation of the asset sold. Proceeds go in CFI.
Carrying amount of asset sold
Opening net PP&E + Capex − Depreciation − Closing net PP&E = Carrying amount of assets sold
Works for net PP&E with no revaluation or impairment.
Change in cash check
CFO + CFI + CFF (+ FX effect) = Change in cash
Your final check. It must tie to the balance sheet.

How to solve Linking Cash Flow Statement to Balance Sheet and Income Statement questions

Use this order for any linkage question, whether it asks for one line item or a whole section.

  1. 1Identify what is asked: a section total (CFO, CFI, CFF) or one item such as dividends paid or proceeds from a sale.
  2. 2List the opening and closing balances of every relevant account and compute each change.
  3. 3Classify each change: operating (working capital), investing (PP&E, investments), or financing (debt, equity, dividends).
  4. 4For operating items, apply the rule: asset up means cash down, liability up means cash up.
  5. 5Remove non-cash items from net income: add depreciation and losses, subtract gains.
  6. 6For asset sales, rebuild the PP&E roll-forward to find the carrying amount, then add the gain or subtract the loss to get proceeds.
  7. 7For equity, use the retained earnings roll-forward to find dividends. For debt, use net change plus any non-cash issuance.
  8. 8Add up the sections and check against the change in cash.

Quickest way: Sign-flip shortcut for the whole statement

When to use it: Use it when you have two balance sheets and need one section total or one line item fast.

  1. Write each balance sheet change as a number: current minus prior.
  2. For assets, flip the sign to get the cash effect. For liabilities and equity, keep the sign.
  3. Sum the operating accounts with net income and depreciation.
  4. For a missing item, solve it from a roll-forward: opening + additions − reductions = closing.
  5. Skip any account the question does not ask about.

Common mistakes in Linking Cash Flow Statement to Balance Sheet and Income Statement

  • Adding an increase in receivables or inventory to CFO

    You see 'increase' and think 'more cash'.

    Fix: An increase in an operating asset means cash is tied up. Subtract it.

  • Adding a gain on sale back in CFO

    You treat all non-cash items like depreciation.

    Fix: A gain already inflated net income. Subtract it in CFO and show the full proceeds in CFI.

  • Using the change in net PP&E as capex

    You forget depreciation and disposals changed the balance.

    Fix: Use the roll-forward: closing = opening + capex − depreciation − carrying amount of assets sold.

  • Treating dividends declared as dividends paid

    Retained earnings shows declared dividends only.

    Fix: Adjust for the change in dividends payable: dividends paid = dividends declared − increase in dividends payable (or + decrease in dividends payable).

  • Including cash or debt in working capital adjustments

    You scan all current accounts without sorting them.

    Fix: Exclude cash. Short-term borrowing and current portion of debt belong in financing.

  • Counting non-cash transactions in the statement

    A debt-for-asset purchase changes the balance sheet.

    Fix: Non-cash investing and financing deals are disclosed separately, not in the cash flows.

Worked examples

Example 1

A company reports net income of $500, depreciation of $120, and a gain on sale of equipment of $30. Accounts receivable rose by $60, inventory fell by $25, and accounts payable rose by $40. Interest and taxes are treated as operating items already included in net income. What is cash flow from operations (indirect method)? A) $555, B) $595, C) $625

Show the solution
  1. Start with net income: 500.
  2. Add depreciation: 500 + 120 = 620.
  3. Subtract the gain on sale: 620 − 30 = 590.
  4. Receivables increased by 60, so subtract: 590 − 60 = 530.
  5. Inventory decreased by 25, so add: 530 + 25 = 555.
  6. Payables increased by 40, so add: 555 + 40 = 595.

Answer: B) CFO = $595. The $30 gain is not in CFO; the sale proceeds appear in investing.

Example 2

Opening net PP&E is $800 and closing net PP&E is $850. Capital expenditure was $150 and depreciation was $90. Equipment sold produced a gain of $20. What were the cash proceeds from the sale? A) $10, B) $30, C) $40

Show the solution
  1. Roll-forward: opening + capex − depreciation − carrying amount sold = closing.
  2. 800 + 150 − 90 − carrying amount = 850.
  3. 860 − carrying amount = 850, so carrying amount sold = 10.
  4. Proceeds = carrying amount + gain = 10 + 20 = 30.

Answer: B) Proceeds = $30, reported as an investing inflow.

Exam tips

  • Questions often hide a missing item. Rebuild it from a roll-forward rather than searching for it.
  • Check the direction: eliminate any option that adds an asset increase to CFO.
  • Gains and losses are the favourite trap. Ask whether the item is already in net income and where the cash belongs.
  • With three options and no penalty, always answer. Estimate the sign and size first, then eliminate.
  • Use about 90 seconds per question. Write the changes in a column and do not recompute the whole statement.

Practice questions from Analyzing Statements of Cash Flows I

Linking Cash Flow Statement to Balance Sheet and Income Statement in other exams

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

Linking Cash Flow Statement to Balance Sheet and Income Statement: frequently asked questions

How does the cash flow statement link to the balance sheet?

Closing cash on the cash flow statement equals cash on the balance sheet. Each section comes from changes in balance sheet accounts: working capital in CFO, long-term assets in CFI, and debt and equity in CFF.

Why subtract a gain on sale of equipment in CFO?

The gain is in net income but is not an operating cash flow. The full sale proceeds are an investing inflow. Subtracting the gain avoids counting it twice.

What is the effect of working capital changes on cash flow from operations?

Increases in operating assets reduce CFO. Decreases in operating assets increase it. Increases in operating liabilities raise CFO, and decreases lower it.

Does depreciation create cash?

No. It is added back only because it reduced net income without using cash. Cash comes from operations; the add-back just reverses a non-cash deduction.