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CFA Level I Exam · Analyzing Statements of Cash Flows II

Cash Flow Statement Linkages and Evaluating Sources of Cash

Updated 7 October 2026 · Fact-checked

Cash flow statement linkages show how cash flow ties to the income statement and balance sheet: net income plus non-cash items and working capital changes gives CFO, and balance sheet changes explain CFI and CFF. To evaluate sources, check whether CFO is positive, sustainable and consistent with earnings, and whether investing and financing flows fit the company's strategy.

Understand Cash Flow Statement Linkages and Evaluating Sources

The cash flow statement explains why cash changed between two balance sheet dates. It is built from the other two statements. Net income comes from the income statement. Changes in assets and liabilities come from comparing two balance sheets.

The indirect method starts with net income and adjusts it. You add back non-cash charges such as depreciation and amortization. You remove non-operating gains and losses, such as a gain on sale of equipment, because the cash from that sale belongs in investing. Then you adjust for changes in working capital. An increase in an operating asset (receivables, inventory) uses cash. An increase in an operating liability (payables, accrued expenses) provides cash.

Investing and financing flows come from the long-term side of the balance sheet. Capex shows up as a rise in PP&E plus depreciation. New debt, repayments, share issues, buybacks and dividends explain changes in debt and equity. Dividends link to retained earnings: ending RE = beginning RE + net income − dividends.

Evaluating sources means asking what kind of cash it is. A healthy mature company funds capex and dividends from operating cash flow. Cash from selling assets or raising debt cannot be repeated forever. Look for CFO that is positive, stable and close to or above net income. If net income is much higher than CFO for several periods, earnings quality is questionable. Rising receivables or inventory, aggressive revenue recognition or capitalized costs can cause this.

Interpret the pattern, not one number. A young growth firm may have negative CFO and positive CFF, which can be normal. A declining firm may show positive CFI from asset sales and negative CFF from debt repayment. Always ask whether the pattern is sustainable and consistent with the business model.

Key formulas to remember

CFO, indirect method
CFO = NI + non-cash charges − non-operating gains (+ non-operating losses) − increase in operating assets + increase in operating liabilities
Under IFRS, interest and dividends received can be in CFO or CFI, and interest and dividends paid can be in CFO or CFF. Under US GAAP, interest paid and received and dividends received are in CFO, and dividends paid are in CFF.
Retained earnings roll-forward
Ending RE = Beginning RE + Net income − Dividends declared
Use it to back out dividends when only RE and net income are given.
Cash collected from customers
Cash from customers = Revenue − increase in accounts receivable (or + decrease)
Assumes no write-offs or other adjustments.
Cash paid to suppliers
Cash paid = COGS + increase in inventory − increase in accounts payable
Reverse the signs for a decrease.
PP&E roll-forward
Ending net PP&E = Beginning net PP&E + Capex − Depreciation − Carrying amount of assets sold
Solve for capex or proceeds. Proceeds = carrying amount + gain (or − loss).
Net change in cash
Change in cash = CFO + CFI + CFF (+ FX effect)
Must equal ending cash minus beginning cash.

How to solve Cash Flow Statement Linkages and Evaluating Sources questions

Use this order for any linkage or source-evaluation question.

  1. 1Identify what is asked: a calculation of a cash flow, or a judgement about quality or sustainability.
  2. 2For a calculation, find the matching balance sheet account and write its roll-forward (beginning + additions − reductions = ending).
  3. 3Decide each item's direction: increase in an asset is a use of cash; increase in a liability or equity is a source.
  4. 4Remove non-cash items and reclassify non-operating gains or losses to investing or financing.
  5. 5Compute the figure and check the sign. Confirm that CFO + CFI + CFF ties to the change in cash.
  6. 6For a judgement, compare CFO with net income, check each section's size and sign, and ask if the pattern matches the company's life cycle.
  7. 7Pick the option that is supported by the numbers, not the one with the most alarming wording.

Quickest way: Sign-and-roll-forward shortcut

When to use it: Use this when a question gives balance sheet changes and asks for a single cash flow item.

  1. Write the account's roll-forward in one line.
  2. Plug in the known items and solve for the missing one.
  3. Asset up = cash down. Liability up = cash up.
  4. For judgement questions, first compare CFO to net income. If CFO is persistently lower, lean toward the low earnings quality option.
  5. Eliminate options that call a one-off source, such as asset sales or new debt, sustainable.

Common mistakes in Cash Flow Statement Linkages and Evaluating Sources

  • Adding an increase in receivables or inventory to net income.

    Students think 'increase' means more cash.

    Fix: An increase in an operating asset ties up cash, so subtract it. An increase in an operating liability adds cash.

  • Leaving a gain on sale of equipment inside CFO.

    The gain is in net income, so it feels operating.

    Fix: Subtract the gain in the CFO reconciliation. The full sale proceeds appear in CFI.

  • Treating depreciation as a source of cash.

    It is added back, so it looks like an inflow.

    Fix: It is only added back because it reduced net income without using cash. It is not a cash source.

  • Calling strong CFF a sign of strength.

    Positive cash looks good.

    Fix: Cash from borrowing or issuing shares is external funding. Ask whether CFO can sustain the business without it.

  • Applying US GAAP classification to an IFRS question.

    Students memorize one rule set.

    Fix: Under IFRS, interest and dividends paid are in CFO or CFF, and interest and dividends received are in CFO or CFI. Under US GAAP, interest paid and received and dividends received are in CFO, and dividends paid are in CFF.

  • Using dividends declared as dividends paid without checking.

    The RE formula gives dividends declared.

    Fix: If dividends payable changed, adjust: cash paid = declared − increase in dividends payable.

Worked examples

Example 1

A company reports net income of $500, depreciation of $80, and a gain on sale of equipment of $20. Accounts receivable rose by $60, inventory fell by $30, and accounts payable rose by $15. Which CFO is correct? A) $525 B) $545 C) $565

Show the solution
  1. Start: net income = 500.
  2. Add depreciation: 500 + 80 = 580.
  3. Subtract the gain: 580 − 20 = 560.
  4. Receivables increased by 60, a use of cash: 560 − 60 = 500.
  5. Inventory fell by 30, a source: 500 + 30 = 530.
  6. Payables rose by 15, a source: 530 + 15 = 545.

Answer: B) $545

Example 2

A company's net PP&E rose from $1,200 to $1,350 during the year. Depreciation was $150. It sold equipment with a carrying amount of $40 at a gain of $10. What was capex, and what were the sale proceeds? A) Capex $280, proceeds $40 B) Capex $280, proceeds $50 C) Capex $340, proceeds $50

Show the solution
  1. Roll-forward: ending = beginning + capex − depreciation − carrying amount sold.
  2. 1,350 = 1,200 + capex − 150 − 40.
  3. 1,350 = 1,010 + capex, so capex = 340.
  4. Proceeds = carrying amount + gain = 40 + 10 = 50.
  5. Capex is a CFI outflow of 340. Proceeds are a CFI inflow of 50.

Answer: C) Capex $340, proceeds $50

Exam tips

  • Practise the sign rule until it is automatic: asset up, cash down; liability up, cash up.
  • Questions often ask which pattern signals poor quality. Persistent CFO below net income and heavy reliance on financing are the usual answers.
  • Read the standard: if no one says US GAAP, assume IFRS and remember its classification choices.
  • With three options, check the sign first. It often eliminates one option immediately.
  • Do not judge from a single year. Prefer answers that talk about trends and sustainability.

Practice questions from Analyzing Statements of Cash Flows II

Cash Flow Statement Linkages and Evaluating Sources 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 Linkages and Evaluating Sources: frequently asked questions

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

Changes in working capital accounts explain adjustments in CFO. Changes in long-term assets, debt and equity explain CFI and CFF. The net change in cash equals the change in the cash line on the balance sheet.

What makes operating cash flow high quality?

It is positive, stable and consistent with or above net income over time. It should also come from core operations rather than one-off items such as working capital releases. It should be enough to fund capex and dividends in a mature firm.

Is negative operating cash flow always bad?

No. A fast-growing company may build receivables and inventory and show negative CFO for a time. It becomes a concern if it persists without a credible path to positive cash flow.

Where does a gain on sale of equipment appear?

The gain is subtracted from net income in the CFO reconciliation under the indirect method. The full cash proceeds are shown in investing activities.