Statement of cash flows: the indirect method with a worked example

What the indirect method does

The statement of cash flows has three sections: operating, investing and financing activities. IAS 7 and ASC 230 allow the operating section to be presented with the direct method (cash received from customers, cash paid to suppliers and staff) or the indirect method (net income adjusted to cash). Most companies use the indirect method, because it comes straight out of the income statement and the balance sheet, and because it shows why profit and cash differ. Under US GAAP a company that uses the direct method has also had to present the reconciliation from net income.

The structure is always the same: net cash from operating activities = net income + non-cash items − gains + losses ± working capital changes.

Step 1: start with net income and add back non-cash items

Depreciation ($1,450,000) and amortization ($210,000) reduced net income, but no cash left the company in the year, so they are added back. Share-based compensation ($175,000) is an expense paid in shares, not cash: add it back too.

The gain on the sale of equipment ($65,000) goes the other way. It raised net income, but the full sale proceeds will appear under investing activities, so leaving the gain in operating cash flow would count part of the proceeds twice. Deduct it. A loss on sale is added back for the same reason. The subtotal, cash flow before working capital changes, is $4,630,000.

Step 2: working capital changes and the sign rule

Compare the operating assets and liabilities on the two balance sheets. The sign rule is the part most people get wrong:

• Asset up = cash down. Receivables rose by $620,000: sales were booked but not yet collected, so the cash effect is −$620,000. Inventory rose by $450,000: −$450,000. Prepaid expenses fell by $30,000: +$30,000.
• Liability up = cash up. Payables rose by $340,000: costs were booked but not yet paid, +$340,000. Accrued liabilities fell by $40,000: −$40,000. Income tax payable rose by $60,000: +$60,000.

In Excel one formula handles both cases: =IF(B8="Asset",-(D8-C8),D8-C8). The total working capital effect is −$680,000: growth tied up cash in receivables and inventory.

Worked example: operating cash flow with the indirect method

Net income, the non-cash items and the two balance sheets are yellow. Column E holds the cash effect of each line. The figures are in USD and the company is fictional.

Worked example: operating cash flow with the indirect method

	A	B	C	D	E
1	Operating activities	Type	31 Dec 2025	31 Dec 2026	Cash effect
2	Net income				2,860,000
3	+ Depreciation				1,450,000
4	+ Amortization of intangibles				210,000
5	+ Share-based compensation				175,000
6	− Gain on sale of equipment				-65,000
7	Cash flow before working capital				4,630,000
8	Accounts receivable	Asset	4,100,000	4,720,000	-620,000
9	Inventory	Asset	5,900,000	6,350,000	-450,000
10	Prepaid expenses	Asset	300,000	270,000	30,000
11	Accounts payable	Liability	3,200,000	3,540,000	340,000
12	Accrued liabilities	Liability	900,000	860,000	-40,000
13	Income tax payable	Liability	250,000	310,000	60,000
14	Working capital effect				-680,000
15	Net cash from operating activities				3,950,000
16	Capital expenditure				-1,800,000
17	Free cash flow (CFO − capex)				2,150,000
18	Cash conversion (CFO ÷ net income)				1.38x

Fictional company, illustrative numbers. General IAS 7 / ASC 230 concepts, simplified. Educational only, not accounting or investment advice.

Step 3: net cash from operating activities

Add the two parts: $4,630,000 − $680,000 = $3,950,000. Investing activities (capital expenditure, proceeds from asset sales, acquisitions) and financing activities (borrowing, repayments, share issues, buybacks and, under US GAAP, dividends paid) follow below. The final check of every statement of cash flows: operating + investing + financing must equal the change in cash between the two balance sheets.

Free cash flow and cash conversion

Two numbers analysts read straight from this section. Free cash flow = operating cash flow − capital expenditure = $3,950,000 − $1,800,000 = $2,150,000. Cash conversion = operating cash flow ÷ net income = 1.38x. A ratio above 1 is normal for a company with large depreciation. A ratio well below 1 year after year means profit is not turning into cash, often because receivables or inventory keep growing faster than sales. The cash conversion cycle shows the same working capital story in days.

What does not belong in the operating section

Cash itself and the current portion of debt are not operating working capital: cash is what the statement explains, and debt is financing. Purchases of equipment are investing, even if they are paid out of operating cash. Classification of interest and dividends differs between frameworks: under US GAAP interest paid is operating, while IAS 7 currently allows a choice that the company must apply consistently (IFRS 18 narrows that choice from 2027). In a full model the statement of cash flows is linked to the other two statements, see the three-statement model example.

Common mistakes

• Getting the working capital signs backwards. An increase in an operating asset reduces cash, an increase in an operating liability increases it.
• Leaving the gain on sale in operating cash flow. The proceeds belong to investing activities. Deduct gains and add back losses.
• Including cash or short-term debt in working capital. Cash is the result of the statement and debt is financing.
• Using the change in net PP&E as capital expenditure. Net PP&E also moves with depreciation and disposals. Back out capex from the PP&E roll-forward.
• Forgetting other non-cash items. Impairments, deferred tax and unrealised gains or losses also need adjusting when they are in net income.
• Skipping the cash check. If operating + investing + financing does not equal the change in cash, something is missing or has the wrong sign.