Last reviewed: July 2026.
The indirect method is widely used to present cash flows from operating activities because it connects accrual profit to cash generated from operations. The method is a reconciliation, not a substitute for accurate cash records.
This guide explains the starting point, non-cash adjustments, working capital movements, investing and financing items, a complete worked example and the review controls needed for an IAS 7 statement of cash flows.
How the indirect method works
The indirect method starts with an accrual-based profit subtotal and reconciles it to cash generated from operations. It removes income and expenses that did not involve operating cash, eliminates items whose cash effects belong in investing or financing activities, and incorporates changes in operating working capital.
The method does not mean that profit equals cash. It explains why the two measures differ. A well-prepared reconciliation lets readers see the effect of depreciation, impairment, gains and losses, receivables, inventories, payables, provisions and other accruals.
Choosing the correct starting point
Under current IAS 7, entities using the indirect method begin with profit or loss and make the required adjustments. Amendments linked to IFRS 18 require the operating profit or loss subtotal as the starting point for annual periods beginning on or after 1 January 2027 when IFRS 18 is applied. Preparers should confirm the effective requirements for the reporting period.
The starting figure must agree to the statement of profit or loss. Using profit after tax and then separately deducting tax without a clear reconciliation can create duplication. The presentation should be consistent from period to period and should explain material classification judgements.
Add back non-cash expenses
Depreciation, amortisation and impairment reduce accounting profit without creating a current-period operating cash payment. They are therefore added back in the operating reconciliation. The same logic applies to non-cash provisions, unrealised foreign exchange movements and share-based payment expense when those items are included in the starting profit subtotal.
An add-back does not mean the expense is unimportant or that the related asset cost never involved cash. It only removes the current period’s non-cash charge from the reconciliation. The original purchase of equipment is normally shown separately as an investing cash outflow when paid.
Remove investing and financing results
A gain on disposal of equipment increases profit but the disposal proceeds are investing cash flow. The gain is therefore deducted from operating profit, while a disposal loss is added back. Interest, dividends and similar items require classification under the applicable IAS 7 and IFRS 18 requirements and the entity’s facts.
Non-cash investing and financing transactions, such as acquiring equipment through a lease without an immediate cash payment, are excluded from the statement of cash flows and disclosed separately when material. Only actual cash and cash-equivalent movements belong in the statement.
Adjust for working capital movements
An increase in trade receivables usually means recognised revenue has not yet produced cash, so it reduces operating cash flow. A decrease normally increases operating cash flow. An increase in inventory usually consumes cash, while a decrease releases cash, subject to non-cash movements and reclassifications.
An increase in trade payables generally preserves cash and is added, while a decrease is deducted. The preparer should use operating balances only and exclude acquisition effects, foreign exchange translation, reclassifications and non-cash movements that would distort the simple opening-to-closing change.
Tax and other operating cash payments
Income taxes paid are normally presented separately and classified as operating unless they can be specifically identified with investing or financing activities under the applicable requirements. The tax expense in profit rarely equals cash paid because of current tax liabilities, refunds, instalments and timing differences.
Interest paid, interest received and dividends require careful classification, especially as IFRS 18-related amendments change some IAS 7 choices. The accounting policy and the reporting period should be checked rather than relying on a memorised rule from an older textbook.
Worked reconciliation example
Suppose operating profit is 150,000. Add depreciation of 24,000 and an impairment loss of 6,000. Deduct a gain on disposal of 5,000. Receivables increased by 18,000, inventory decreased by 7,000 and payables increased by 11,000. Cash generated from operations before tax and interest is 175,000.
The calculation is 150,000 + 24,000 + 6,000 − 5,000 − 18,000 + 7,000 + 11,000. Each adjustment should be traceable to a ledger balance, note or supporting schedule. A reconciliation that cannot be traced is difficult to review and can conceal classification errors.
Common errors and review controls
Frequent errors include reversing the sign of working capital changes, including cash balances in working capital, adding back asset purchases, treating loan movements as operating, and using balance-sheet differences without removing acquisition or foreign-exchange effects.
Good controls include a cash-flow mapping for every ledger account, a movement schedule for working capital, separate non-cash transaction logs, agreement of opening and closing cash, and an independent review of classification. The final net change must reconcile exactly to cash and cash equivalents.
Practical review checklist
- Agree the starting profit subtotal to the financial statements.
- Identify every non-cash expense and income item.
- Remove gains, losses and cash flows classified outside operations.
- Analyse receivables, inventories and payables using clean movement schedules.
- Separate acquisition, disposal and foreign-exchange effects.
- Check tax, interest and dividend classifications for the reporting period.
- Disclose material non-cash investing and financing transactions.
- Reconcile opening and closing cash and obtain independent review.
Related Accounting Support guides
- IAS 7 statement of cash flows practical guide
- How to prepare a statement of cash flows
- Links between cash flow and other statements
Authoritative references
This educational guide explains general accounting principles. Apply the reporting framework, law and market rules relevant to the entity and jurisdiction.