How do I prepare a cash flow statement using the indirect method?

This type of question is testing whether you understand the difference between profit and cash. A business can report a profit and still have weak cash flow because customers have not paid, inventory has increased, or cash has been used to repay debt. Under IAS 7, a statement of cash flows classifies movements as operating, investing and financing activities, and the indirect method adjusts profit for non-cash items and accruals.

What the question is asking

The assignment is not asking you to rewrite the income statement. It is asking you to explain how cash moved during the period and to reconcile the opening cash balance to the closing cash balance. The hidden task is to identify which accounting numbers are non-cash, which balance sheet movements affect operating cash, and which items belong outside operating activities.

Key concepts to cover

• Operating activities: cash flows from the main revenue-producing activity
• Non-cash expenses: depreciation, amortisation, impairment and similar charges
• Working capital: inventory, trade receivables and trade payables
• Investing activities: purchase or sale of non-current assets and investments
• Financing activities: share issues, borrowings, loan repayments and dividends
• Reconciliation: opening cash plus net cash movement equals closing cash
• Classification: interest and dividends must be treated consistently with the accounting standard and your module guidance

Suggested answer structure

1. 1State the purpose of the statement of cash flows.
2. 2Start with profit before tax or net income, depending on the data given.
3. 3Add back non-cash expenses such as depreciation.
4. 4Remove gains or losses that belong in investing activities.
5. 5Adjust for working capital movements.
6. 6Deduct tax paid if the question asks for cash flow from operations after tax.
7. 7Present investing and financing sections.
8. 8Reconcile the net change in cash to the opening and closing balance.

Mini worked example

Suppose a company reports profit before tax of 50,000. Depreciation is 8,000. Inventory increased by 6,000, trade receivables decreased by 4,000 and trade payables increased by 3,000. Ignore tax for this small example.

• Start with profit before tax: 50,000
• Add depreciation because it reduced profit but did not use cash: +8,000
• Inventory increased, so cash was tied up in stock: -6,000
• Receivables decreased, so customers paid cash: +4,000
• Payables increased, so the company delayed cash payment to suppliers: +3,000

Cash generated from operations is 59,000. The logic matters more than memorising signs. Ask what happened to cash. More receivables means cash not yet collected, so subtract. More payables means cash not yet paid, so add.

Common mistakes

• Adding every balance sheet increase without thinking about cash direction
• Forgetting to add back depreciation and amortisation
• Treating purchase of equipment as an operating cash flow instead of investing
• Mixing dividends paid into operating activities when the assignment expects financing
• Forgetting that profit on disposal is not the same as cash proceeds from disposal
• Failing to reconcile the final figure to the closing cash balance

How to make the answer stronger

Markers usually reward a short explanation beside the calculation. For example, do not only write "increase in receivables: subtract". Add that the increase means revenue has been recognised before cash was collected. That one sentence shows you understand accrual accounting rather than only following a template.

If the question provides two years of balance sheets, use the movement between the years, not the closing balance alone. If inventory rose from 20,000 to 27,000, the operating cash adjustment is 7,000, not 27,000.

Related questions

• What is the difference between accruals and cash accounting in practice?
• How do I calculate NPV when the cash flows are different every year?
• How do I calculate liquidity and profitability ratios for a retail company?
• How do I prepare a cash budget for a small business?

Academic use note

This guide is for accounting assignment planning and study support. Use it to understand the method, then apply your own module data, marking rubric and required accounting standard.

Sources and further reading

• IFRS IAS 7 Statement of Cash Flows