Updated for the 2026-2027 CFA® Level I curriculum.
Preparing a cash flow statement means building three sections, operating, investing, and financing, from income statement and balance sheet data. The operating section can be presented two ways: the direct method or the indirect method. Both require the same classification work. Level I tests whether you can build the operating section correctly under each method and explain why they produce identical totals.
Quick Answer
The direct and indirect methods are two ways to present cash flow from operating activities. The direct method lists actual cash receipts and cash payments. The indirect method starts with net income and adjusts for non-cash items and working capital changes. Both methods produce the same total operating cash flow. Only the presentation differs. Investing and financing sections are identical under either method.
Key Takeaways
The direct and indirect methods differ only in how they present cash flow from operating activities. Both produce the same CFO total.
The direct method reports cash collected from customers and cash paid to suppliers, employees, and other operating expenses.
The indirect method starts with net income and adjusts for non-cash expenses, non-operating gains and losses, and changes in working capital accounts.
Classifying a transaction as operating, investing, or financing determines which section of the statement it belongs in.
Non-cash investing and financing transactions are disclosed in a supplemental note, never reported inside the cash flow statement itself.
Increases in operating working-capital assets generally reduce CFO. Increases in operating working-capital liabilities generally increase CFO; cash, debt, and non-cash changes require separate treatment. Decreases work in the opposite direction.
What You Need to Know for CFA Level I
The LOS asks you to describe the steps for preparing both direct and indirect cash flow statements, including computing cash flows from income statement and balance sheet data.
You must classify each transaction as operating, investing, or financing before building either version of the statement.
You need to know the direct method calculation (cash collections and cash payments) and the indirect method reconciliation (starting from net income).
This note covers building a statement from underlying accrual data. Converting an already-prepared indirect statement into direct format is a separate skill, covered in the next note.
The most common exam trap is reversing the direction of a working capital adjustment or leaving a gain or loss on asset sale inside the operating section.
Classifying Business Activities Before You Prepare the Statement
Before you can prepare either version of the cash flow statement, you need to sort transactions into three categories.
Category | What It Covers | Typical Examples |
|---|---|---|
Operating | Cash effects of the core revenue-generating business | Collections from customers, payments to suppliers and employees, interest received (US GAAP) |
Investing | Cash effects of buying and selling long-term assets | Purchase of equipment, sale of securities, acquisition of another business |
Financing | Cash effects of raising or repaying capital | Issuing debt, issuing stock, paying dividends, repaying loan principal |
Get the classification right first. A misclassified transaction throws off every section of the statement, not just one.
Preparing Cash Flow from Operations: The Direct Method
What the Direct Method Reports
The direct method reports actual cash inflows and outflows tied to operations. Each line shows real cash movement: cash collected from customers, cash paid to suppliers, cash paid to employees, cash paid for other operating expenses.
Steps to Build the Direct Method Section
Start with each income statement revenue and expense line tied to operations.
Adjust each line for the change in the related balance sheet account.
Sum the adjusted cash receipts and cash payments to get operating cash flow.
The core adjustments:
where:
Sales: sales revenue from the income statement,
: change in accounts receivable (an increase is subtracted, a decrease is added),
COGS: cost of goods sold from the income statement,
: change in inventory (an increase is added, a decrease is subtracted), and
: change in accounts payable (an increase is subtracted, a decrease is added).
Cash paid for other operating expenses follows the same logic. Adjust the expense line for any related accrued liability or prepaid asset change.
Preparing Cash Flow from Operations: The Indirect Method
What the Indirect Method Reports
The indirect method starts with net income, a number built on accrual accounting, and removes everything that did not involve cash this period.
Steps to Build the Indirect Method Section
Start with net income.
Add back non-cash expenses like depreciation and amortization.
Remove non-operating gains and add back non-operating losses.
Adjust for changes in working capital accounts tied to operations.
where:
NI: net income,
D&A: depreciation and amortization expense, added back because it is non-cash,
Gains: gains on sale of long-term assets, removed because they belong in investing activities,
Losses: losses on sale of long-term assets, added back because they belong in investing activities,
: change in accounts receivable,
: change in inventory, and
: change in accounts payable.
Direct vs Indirect: Side-by-Side
Feature | Direct Method | Indirect Method |
|---|---|---|
Starting point | Individual revenue and expense lines | Net income |
Shows | Actual cash receipts and payments | Reconciliation from accrual to cash |
Easier to build from | Cash receipts journals | Existing income statement and balance sheet |
CFO total | Identical | Identical |
Investing and Financing Activities Are the Same Under Both Methods
The method choice only affects the operating section. Investing activities list cash flows from buying and selling long-term assets. Financing activities list cash flows from debt and equity transactions. These two sections look identical whether the company presents operating activities under the direct or indirect method.
Reporting Non-Cash Investing and Financing Activities
Some transactions affect long-term assets, debt, or equity without any cash changing hands. Examples include issuing stock to acquire equipment or converting bonds into common shares. These transactions never appear inside the operating, investing, or financing sections. They are disclosed in a supplemental schedule or footnote because no cash moved.
Working Example
Bluepeak Robotics reports the following for the year:
Sales revenue: $900,000
Cost of goods sold: $500,000
Depreciation expense: $40,000
Other operating expenses (paid in cash): $200,000
Gain on sale of equipment: $5,000
Net income: $165,000
Balance sheet changes during the year:
Accounts receivable increased $20,000
Inventory decreased $10,000
Accounts payable increased $15,000
Direct method
Cash collected from customers:
Cash paid to suppliers:
Cash paid for other operating expenses: $200,000 (no accrual change, paid in full)
Operating cash flow (direct):
Indirect method
Start with net income: $165,000
Add back depreciation: +$40,000
Remove gain on sale of equipment: -$5,000
Subtract increase in accounts receivable: -$20,000
Add decrease in inventory: +$10,000
Add increase in accounts payable: +$15,000
Operating cash flow (indirect):
Both methods report in operating cash flow. The direct method shows this as actual cash collected minus actual cash paid out. The indirect method shows the same number by starting with accrual-based net income and stripping out non-cash items. An analyst sees the same cash result either way, but the indirect method also reveals how far net income diverges from cash, useful for spotting aggressive revenue recognition or working capital strain.
Common Exam Traps
Assuming the method changes the total
The direct and indirect methods always produce the same operating cash flow. If your two totals disagree, you made an arithmetic or sign error, not a methodology choice.
Reversing the direction of a working capital adjustment
An increase in a current asset like accounts receivable or inventory uses cash and gets subtracted. An increase in a current liability like accounts payable provides cash and gets added. Check whether each change relates to an operating asset or liability before choosing its sign.
Leaving a gain or loss inside the operating section
A gain on sale of equipment increases net income but belongs to investing activities. Under the indirect method, you must remove the gain (subtract it) or add back the loss, because the full sale proceeds show up in investing activities instead.
Reporting non-cash transactions inside the statement
Issuing stock for equipment, or converting debt to equity, never appears in the operating, investing, or financing totals. These belong in a supplemental disclosure because no cash moved.
Confusing preparation with conversion
This note builds each method from scratch using income statement and balance sheet data. Converting an already-completed indirect statement into direct format uses a different formula set and is covered in the next note.
Practice Question
Orchid Foods reported net income of $82,000. Depreciation expense was $15,000. Accounts receivable increased by $6,000, and accounts payable decreased by $4,000. The company also recognized a $3,000 loss on the sale of equipment. Using the indirect method, what is Orchid's cash flow from operating activities?
$84,000
$90,000
$98,000
Correct Answer: Option B
Start with net income and apply each adjustment in order.
Operating cash flow equals $90,000.
Option A: This result comes from subtracting the loss instead of adding it back. A loss reduces net income but relates to investing activities, so it must be added back, not subtracted again.
Option C: This result comes from treating the decrease in accounts payable as a source of cash instead of a use of cash. A decrease in a liability means the company paid down obligations, which uses cash and must be subtracted.
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FAQs About Direct and Indirect Cash Flow Statement Preparation
What is the difference between the indirect and direct cash flow statement methods?
The direct method lists actual cash receipts and payments from operations. The indirect method starts with net income and adjusts for non-cash items and working capital changes. Both arrive at the same operating cash flow total.
Does the direct method give a different operating cash flow number than the indirect method?
No. Both methods produce the identical operating cash flow figure. They only differ in presentation and in how much detail they show about cash sources and uses.
Which method does CFA Level I require candidates to know?
Both. The LOS specifically asks you to describe the preparation steps for both the direct and indirect methods, including how to compute cash flows from income statement and balance sheet data.
Where do non-cash transactions appear on the cash flow statement?
They do not appear in the operating, investing, or financing sections. Significant non-cash transactions, like issuing stock to buy equipment, are disclosed in a supplemental note because no cash changed hands.
Why do most companies use the indirect method instead of the direct method?
The indirect method is easier to build directly from existing income statement and balance sheet data. The direct method requires reclassifying each revenue and expense line into actual cash receipts and payments, which takes more detailed records.