Learning Module 4
Analyzing Statements of Cash Flows I
Key Outcomes Summary & Practice Problems
What you must be able to do
Curriculum Year: 2026
Describe how the cash flow statement is linked to the income statement and the balance sheet — the interrelationships among all four primary financial statements.
Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.
Demonstrate the conversion of cash flows from the indirect to the direct method using a three-step process.
Contrast cash flow statements prepared under IFRS and US GAAP — particularly classification flexibility for interest, dividends, and income taxes.
1 · Linkages Between the Financial Statements
All four primary financial statements are interlinked. The balance sheet is a snapshot at a point in time; the income statement, statement of cash flows, and statement of shareholders' equity are "flow" statements connecting two balance sheet dates.
Key linkage chain:
Beginning Balance Sheet → (Income Statement + Cash Flow Statement + S/H Equity Statement) → Ending Balance Sheet
Specifically: Beginning Cash + Operating CF + Investing CF + Financing CF = Ending Cash
And: Beginning Retained Earnings + Net Income − Dividends = Ending Retained Earnings
Current assets/liabilities linkage: The income statement and cash flow statement link current balance sheet items:
• Accrual revenue > cash collected → accounts receivable increases
• Cash paid for expenses > accrual expense → prepaid assets increase (or payables decrease)
• Cash received in advance → deferred revenue liability (derecognised when performance obligation satisfied)
Key formula: Beginning A/R + Revenue − Cash collected from customers = Ending A/R
Four Primary Financial Statement Transaction Examples
Transaction | Balance Sheet | Income Statement | Cash Flow Statement |
|---|---|---|---|
Inventory purchase on credit (30-day terms) | Inventory↑; A/P↑ | None yet | None yet |
Pay supplier 30 days later | Cash↓; A/P↓ | None | OCF↓ (cash out) |
Sell inventory on credit | A/R↑; Inventory↓ | Revenue↑; COGS↑ | None yet (not cash) |
Collect from customer | Cash↑; A/R↓ | None | OCF↑ (cash in) |
Buy equipment for cash | Equipment↑; Cash↓ | None (asset) | ICF↓ (investing outflow) |
Depreciation at year-end | Accum. Depr.↑ | Depr. Expense↑ | None (non-cash) |
Borrow from bank | Cash↑; Loan payable↑ | None | FCF↑ (financing inflow) |
Repay loan + interest | Cash↓; Loan payable↓ | Interest Expense↑ | FCF↓ (principal); OCF↓ (interest, US GAAP) |
Receive advance payment | Cash↑; Deferred Revenue↑ | None yet | OCF↑ (cash in) |
Deliver goods/service (fulfil obligation) | Deferred Revenue↓ | Revenue↑ | OCF↑ (remaining cash on delivery) |
Three Sections of the Cash Flow Statement
Cash effects of transactions affecting income: cash received from customers, cash paid to suppliers, cash paid to employees, cash paid for interest (US GAAP), cash paid for taxes. Both direct and indirect methods used. Most important section for analysts.
Cash flows from acquiring/disposing of long-term assets and investments: purchase/sale of equipment, buildings, land; purchase/sale of investments; loans made to others. Always presented using the direct method.
Cash flows from transactions with the company's capital providers: proceeds from issuing debt/equity, repayment of debt, stock buybacks, dividend payments. Always direct method. Note: dividends paid classified as financing under US GAAP (IFRS allows operating).
2 · Direct Method for Operating Cash Flows
The direct method lists each major category of operating cash receipts and payments. Each is computed by adjusting the related income statement item for changes in the relevant balance sheet accounts.
Cash received from customers = Revenue − Increase in A/R
(OR: Revenue + Decrease in A/R)
Acme 2018: USD23,598 − USD55 (A/R↑) = USD23,543
Intuition: if A/R increased, you billed more than you collected → cash < revenue
If A/R decreased, you collected more than you billed → cash > revenue
Full reconciliation: Beg. A/R + Revenue − Cash collected = End. A/R
USD957 + 23,598 − 23,543 = USD1,012 ✓
Step 1 — Purchases = COGS + Increase in Inventory (OR: COGS − Decrease in Inventory)
Step 2 — Cash paid = Purchases − Increase in A/P (OR: Purchases + Decrease in A/P)
Acme 2018:
Purchases = USD11,456 + USD707 (Inventory↑) = USD12,163
Cash paid = USD12,163 − USD263 (A/P↑) = USD11,900
Intuition: more inventory bought than COGS → purchases > COGS
A/P rose → some purchases not yet paid → cash paid < purchases
Cash paid to employees = Salary expense − Increase in Salary payable
(OR: Salary expense + Decrease in Salary payable)
Acme 2018: USD4,123 − USD10 (Salary payable↑) = USD4,113
Cash paid for other operating expenses:
= Other op. expenses + Increase in Prepaid − Increase in Accrued liabilities
Acme: USD3,577 − USD23 (Prepaid↓) − USD22 (Accrued liab↑) = USD3,532
Cash paid for interest (US GAAP — always OCF):
= Interest expense + Decrease in Interest payable
Acme: USD246 + USD12 (Interest payable↓) = USD258
Cash paid for income taxes:
= Tax expense − Increase in Tax payable − Increase in Deferred tax liability
Acme: USD1,139 − USD5 (Tax payable↑) = USD1,134
Acme Direct Method Operating Cash Flow Summary:
Cash received from customers: +USD23,543 | Cash paid to suppliers: −USD11,900 | Cash paid to employees: −USD4,113 | Cash paid for other operating expenses: −USD3,532 | Cash paid for interest: −USD258 | Cash paid for income taxes: −USD1,134 | Net Operating CF: +USD2,606
3 · Indirect Method for Operating Cash Flows
The indirect method (most commonly used) starts with net income and adjusts for: (1) non-operating items, (2) non-cash items, and (3) changes in working capital. The result is the same operating cash flow as the direct method.
Non-cash expenses: Depreciation, amortisation, depletion, bond discount amortisation
Non-operating losses: Loss on sale of assets, loss on debt retirement
Working capital changes:
↓ Current operating assets (A/R↓, Inventory↓, Prepaid↓)
↑ Current operating liabilities (A/P↑, Accrued liabilities↑, Wages payable↑)
Increase in deferred tax liability
Non-cash income: Bond premium amortisation
Non-operating gains: Gain on sale of assets, gain on debt retirement
Working capital changes:
↑ Current operating assets (A/R↑, Inventory↑, Prepaid↑)
↓ Current operating liabilities (A/P↓, Accrued liabilities↓, Interest payable↓)
Decrease in deferred tax liability
Acme Indirect Method (to same USD2,606 OCF):
Net income: USD2,210 | + Depreciation: +1,052 | − Gain on equipment sale: −205 | − A/R increase: −55 | − Inventory increase: −707 | + Prepaid decrease: +23 | + A/P increase: +263 | + Salary payable increase: +10 | − Interest payable decrease: −12 | + Tax payable increase: +5 | + Accrued liabilities increase: +22 | = Net OCF: USD2,606
Depreciation is added back because it reduced net income but required no cash outflow. The actual cash outflow for the asset occurred in the past (when purchased — shown as investing outflow).
Gains on asset sales are subtracted (not removed from OCF — the full cash proceeds appear in investing activities, so the gain portion would be double-counted if left in OCF).
Memory rule for working capital: Current asset increases → subtract (used cash but not yet matched in income). Current liability increases → add (received the benefit but haven't paid yet). Opposite for decreases.
4 · Investing & Financing Activities
Finding cash received from sale of PP&E:
Step 1: Historical cost sold = Beg. equipment + Purchases − End. equipment
Acme: USD8,555 + USD1,300 − USD8,798 = USD1,057
Step 2: Accum. depr. on sold = Beg. accum. depr. + Depr. expense − End. accum. depr.
Acme: USD2,891 + USD1,052 − USD3,443 = USD500
Step 3: Book value = Historical cost − Accumulated depreciation
= USD1,057 − USD500 = USD557
Step 4: Cash received = Book value + Gain (or − Loss)
= USD557 + USD205 (gain) = USD762
Compute dividends from retained earnings:
Beg. RE + Net income − Dividends paid = End. RE
→ Dividends paid = Beg. RE + Net income − End. RE
Acme: USD2,876 + USD2,210 − USD3,966 = USD1,120
Acme full investing & financing summary:
ICF: Cash from equipment sale +762; Equipment purchase −1,300 → Net ICF = −538
FCF: Retire LT debt −500; Retire common stock −600; Dividends −1,120 → Net FCF = −2,220
Net change in cash = +2,606 − 538 − 2,220 = −152 (confirmed by BS: 1,163 → 1,011)
5 · Converting Indirect to Direct Method
Disaggregate net income into total revenues and total expenses. All income statement line items separated: revenues, COGS, salary expense, depreciation, other operating expenses, gains/losses, interest expense, tax expense.
Remove all non-cash and non-operating items from the aggregated revenue and expense totals. For Acme: remove depreciation (USD1,052) from expenses and remove gain on equipment sale (USD205) from revenues. What remains is purely cash-generating revenues and cash-consuming expenses on an accrual basis.
Convert accrual amounts to cash flows by adjusting each line for relevant balance sheet changes. Apply: Revenue → subtract A/R increase → Cash from customers. COGS + Inventory change → adjust for A/P change → Cash to suppliers. And so on for each cash payment category.
Why convert? Indirect operating cash flow (the most common format) can obscure operating trends. The direct method clearly shows trends in cash receipts from customers and cash payments to suppliers — useful for detecting early warning signs (e.g., revenue growing but cash collections not keeping pace → receivables quality issue).
6 · IFRS vs US GAAP Classification Differences
Item | IFRS Classification | US GAAP Classification |
|---|---|---|
Interest received | Operating OR Investing | Operating only |
Interest paid | Operating OR Financing | Operating only |
Dividends received | Operating OR Investing | Operating only |
Dividends paid | Operating OR Financing | Financing only |
Income taxes paid | Generally Operating; portion can be Investing/Financing if specifically identifiable | Operating only |
Bank overdrafts | Considered part of cash equivalents | Not cash; classified as financing |
Format of statement | Direct or indirect; direct encouraged | Direct or indirect; direct encouraged; must provide indirect reconciliation regardless |
Key US GAAP rigidity: interest paid is always operating, dividends paid is always financing — no flexibility. IFRS gives management discretion to classify these in ways that optimise the appearance of operating cash flow.
IFRS comparative advantage: classifying interest paid as financing activity increases reported OCF; classifying dividends received as investing increases OCF. This makes IFRS companies potentially appear to generate more operating cash flow — analysts must adjust for comparability.
Both require disclosure of taxes paid: cash paid for income taxes must be separately disclosed under both IFRS and US GAAP (either in the statement or in the notes).