How to prepare a cash flow statement: the indirect method, step by step

The statement of cash flows explains how a business's cash and cash equivalents changed over a period. It's the one primary statement that isn't prepared on the accrual basis, which makes it the best check on whether reported profit is turning into cash.

Under IFRS the rules are in IAS 7 Statement of Cash Flows; under US GAAP, in ASC 230. This guide prepares one from scratch, checks it two ways, and then shows what changes for IFRS reporters from 2027.

The three categories

Cash equivalents are short-term, highly liquid investments readily convertible to known amounts of cash and subject to an insignificant risk of changes in value — typically deposits with a maturity of three months or less from acquisition. Under IFRS, a bank overdraft repayable on demand that forms an integral part of cash management can be included in cash and cash equivalents.

Non-cash investing and financing transactions — acquiring a building in exchange for shares, or a new lease recognised as a right-of-use asset — are left out of the statement and disclosed in the notes.

Two ways to present operating cash flows

• The direct method lists the main classes of gross receipts and payments: cash from customers, cash paid to suppliers, cash paid to employees.
• The indirect method starts with profit and adjusts it for non-cash items, for items that belong in investing or financing, and for movements in working capital.

Both give the same net operating cash flow. IAS 7 encourages the direct method, but most companies use the indirect method, and it's what most exams and interview tests ask for. Investing and financing sections are the same under both.

The worked example: Pellham Tools Ltd

Pellham Tools prepares IFRS statements for the year ended 31 December 2026 and presents interest paid in operating activities (a choice IAS 7 allows for 2026).

Income statement for 2026

Statements of financial position at 31 December

Other information. Equipment with a carrying amount of 20,000 was sold for 25,000. New equipment cost 90,000. Dividends of 35,000 were paid. No new loans were taken out.

Step 1: start from profit and remove non-cash items

Start with profit before tax, 100,000, so that tax and interest can be shown separately as cash paid. Then:

• Add back depreciation, 40,000. It reduced profit but no cash left the business.
• Deduct the gain on disposal, 5,000. The gain isn't cash; the full 25,000 of proceeds will appear in investing.
• Add back interest expense, 15,000. The cash actually paid will be shown separately.

Step 2: adjust for working capital

For assets, an increase uses cash and a decrease releases it. For liabilities, it's the other way round.

• Receivables rose 15,000: customers paid less than the revenue recorded. Deduct 15,000.
• Inventories fell 10,000: some of cost of sales came out of existing stock rather than new purchases. Add 10,000.
• Prepayments rose 2,000: cash was paid ahead of the expense. Deduct 2,000.
• Trade payables rose 8,000: some expenses haven't been paid yet. Add 8,000.

Step 3: interest and tax actually paid

Work out cash paid from the opening liability, the charge and the closing liability:

• Interest paid = 3,000 + 15,000 − 2,000 = 16,000
• Tax paid = 12,000 + 25,000 − 14,000 = 23,000

Step 4: investing and financing

• Purchase of equipment, 90,000. Check it with a property, plant and equipment roll-forward: 300,000 − 20,000 disposed + 90,000 bought − 40,000 depreciation = 330,000. ✓
• Disposal proceeds, 25,000 (carrying amount 20,000 + gain 5,000).
• Share issue, 50,000 (the change in share capital).
• Loan repaid, 30,000.
• Dividends paid, 35,000. Check against retained earnings: 101,000 + 75,000 − 35,000 = 141,000. ✓

The statement

The net increase of 32,000 matches the change in cash on the statement of financial position: 112,000 − 65,000 − 15,000 = 32,000. If it doesn't match, a balance sheet movement has been missed or counted twice.

Cross-check with the direct method

• Receipts from customers = revenue 900,000 − increase in receivables 15,000 = 885,000.
• Payments to suppliers and employees = cost of sales 540,000 + operating expenses excluding depreciation 210,000 = 750,000; less the fall in inventory (10,000), plus the rise in prepayments (2,000), less the rise in payables (8,000) = 734,000.
• Cash generated from operations = 885,000 − 734,000 = 151,000 — the same as the indirect method.

Build either version step by step in the cash flow statement builder.

Interest and dividends: today and from 2027

For 2026 IFRS reporting, IAS 7 gives entities that aren't financial institutions a choice, applied consistently from period to period: interest paid can be operating or financing; interest received and dividends received can be operating or investing; dividends paid can be operating or financing. US GAAP (ASC 230) generally classifies interest paid, interest received and dividends received as operating, and dividends paid as financing.

From 2027 under IFRS. IFRS 18 Presentation and Disclosure in Financial Statements applies to annual periods beginning on or after 1 January 2027 (earlier application permitted), and when it was issued in April 2024 the IASB also amended IAS 7. For an entity whose main business isn't providing finance to customers or investing in assets — most trading and service companies — the amendments:

• make the IFRS 18 operating profit subtotal the starting point for the indirect method;
• classify interest paid and dividends paid as financing cash flows;
• classify interest received and dividends received as investing cash flows.

Banks, investment entities and other entities with specified main business activities follow different rules for some of these items.

Pellham Tools under the 2027 rules. If Pellham applied the amendments, the indirect method would start from operating profit of 115,000 — interest expense sits below that subtotal, so there's nothing to add back — and interest paid would move to financing:

The total doesn't change; the classification does. Operating cash flow rises by the 16,000 of interest paid. Comparatives are restated on first application, so a December year-end company first reporting under IFRS 18 in its 2027 statements will present 2026 on the new basis too. When you compare operating cash flows across companies or years around 2027, check which basis each figure uses.

Common mistakes

• Getting working-capital signs backwards. An increase in an asset is a cash outflow; an increase in a liability is a cash inflow.
• Leaving the gain on disposal in operating cash flow and also showing the proceeds in investing, which double-counts the gain.
• Using the interest or tax expense instead of cash paid.
• Showing the carrying amount of a disposal instead of the proceeds in investing.
• Including non-cash transactions such as assets acquired under new leases or for shares.
• Mixing classification policies within one statement, or across years without restating.

Frequently asked questions

Why does depreciation appear as a positive number?

It isn't a source of cash. It's added back because it was deducted in arriving at profit without any cash leaving the business.

Where do lease payments go?

Under IFRS 16, the principal portion of lease payments is financing; interest on the lease liability follows the entity's interest-paid classification (financing for most entities under the 2027 rules).

Is a negative operating cash flow always bad?

Not always — a fast-growing business may invest heavily in receivables and inventory. But persistent negative operating cash flow alongside reported profits is a warning sign worth investigating.

Practise it

Start with profit versus cash flow, then the graded lessons on the indirect method, the direct method and investing and financing activities. The statement linking lab shows how each accrual choice moves cash flow, and The Financial Reporting Review case asks you to review a draft set of statements. The IFRS financial reporting pathway continues from here.