Understanding the Indirect Method
The indirect method of cash flows starts with profit and adjusts for non-cash items, for items whose cash effect belongs in investing or financing activities, and for movements in working capital. Depreciation reduces profit without paying anyone; a sale on credit increases profit before the customer settles. Reverse the first and adjust for the second, and what remains is cash generated from operations.
Both IAS 7 and ASC 230 express a preference for the direct method, yet the indirect method dominates in practice because every input it needs already sits in the statement of financial position and the statement of profit or loss. The direct method requires the underlying receipts and payments to be extracted or reconstructed.
Indirect Method Cash Flow Statement Format
The operating section takes the following shape. The figures are those used in the example later in this article.
| Statement of cash flows for the year ended 31 December 2026 | Amount |
|---|---|
| Cash flows from operating activities | |
| Profit before tax | 701,000 |
| Adjustments for: | |
| Depreciation of property, plant and equipment | 248,000 |
| Depreciation of right-of-use assets | 62,000 |
| Amortisation of intangible assets | 30,000 |
| Gain on disposal of plant | (22,000) |
| Share of profit of associate | (65,000) |
| Finance costs | 78,000 |
| Operating cash flow before working capital changes | 1,032,000 |
| Changes in working capital: | |
| Increase in inventories | (74,000) |
| Increase in trade receivables | (91,000) |
| Increase in prepayments | (9,000) |
| Increase in trade payables | 12,000 |
| Increase in accruals | 10,000 |
| Cash generated from operations | 880,000 |
| Interest paid | (75,000) |
| Income tax paid | (153,000) |
| Net cash from operating activities | 652,000 |
Choosing the Starting Point
IAS 7 does not prescribe which profit subtotal the reconciliation begins with. Three are used in practice, and the choice determines which adjustments are needed.
| Starting point | Consequence for the adjustment layer |
|---|---|
| Profit before tax | The tax charge never enters the reconciliation, so no add-back for current or deferred tax is required. Tax paid is presented as its own line. |
| Profit after tax | The full tax charge must be added back, including the deferred tax element, before tax paid is presented separately. |
| Operating profit | Finance costs, investment income and share of associate results sit below the subtotal and never need reversing, but every item presented below operating profit must be checked for a cash effect. |
Profit before tax is the most common choice, and it is the one used throughout this article. It avoids the deferred tax add-back entirely: because deferred tax is only ever a component of the tax charge, starting above that charge removes it from consideration.
The choice is not permanent. IFRS 18 amends IAS 7 to mandate operating profit as the single starting point, which is covered in the IFRS 18 section below.
Reversing Non-Cash Items
IAS 7 paragraph 20 sets out what the adjustment layer must cover, and it splits into three categories rather than one undifferentiated list of add-backs:
| IAS 7 paragraph 20 category | Items |
|---|---|
| Changes in inventories and operating receivables and payables | Handled as working capital movements, covered in the next section. |
| Non-cash items | Depreciation, provisions, deferred taxes, unrealised foreign exchange differences and undistributed profits of associates are the examples the standard names explicitly. |
| All other items whose cash effects are investing or financing cash flows | Disposal gains and losses, finance costs and investment income. |
The second and third categories form the adjustment layer proper, and separating them prevents most reconciliation errors.
Reverse items that did not have a cash impact. Depreciation, amortisation, impairment losses, expected credit loss charges, inventory write-downs, movements in provisions and equity-settled share-based payment expenses all reduce profit without a payment. Each is added back. Non-cash income, such as the reversal of an impairment or a fair value gain, is deducted.
Reverse items whose cash flow is presented elsewhere. Finance costs, investment income, the share of an associate's profit and gains or losses on disposal all moved cash, or will, but not within operating activities. Reversing the profit or loss amount clears the way for the actual cash flow to be presented in its proper section.
Presenting the Adjustments
How the adjustments are presented matters as much as identifying them, and three points govern it.
Each major class appears on its own line. Aggregating the adjustment layer into a single "adjustments for non-cash items" figure defeats the purpose of the reconciliation, which exists to show a reader why profit and cash diverged. Depreciation, impairment, disposal gains, finance costs and the share of associate results are separately meaningful and are presented separately.
Adjustments are never netted against one another. An impairment loss of 40,000 and a reversal of 15,000 are presented as two figures, not as a net 25,000. The same applies to disposal gains and losses arising on different assets. Netting removes precisely the information the line was added to convey, and it obscures the link back to profit or loss.
The reconciliation may sit on the face or in a note. IAS 7 permits the operating section to be presented either way, and practice differs: many entities present cash generated from operations on the face of the statement and place the reconciliation from profit before tax in a note. ASC 230 takes the same approach, permitting the reconciliation to be reported within the statement or in a separate schedule. Whichever is chosen, the subtotals and their captions stay the same.
A fourth point sits alongside these rather than within them. Some items are not adjustments at all because they never entered profit or loss: a right-of-use asset recognised at commencement, an asset acquired on credit, or shares issued as consideration. These are excluded from the statement entirely and disclosed as non-cash transactions under IAS 7 paragraph 43, which is covered in the disclosure section below. The distinction is worth holding onto: an adjustment reverses something that is in profit, while a non-cash transaction is something that was never in profit and must be kept out of investing and financing as well.
Adjustments Most Often Missed
The individual adjustments are set out in our line-by-line list of cash flow statement adjustments. The items below are the ones most often absent from a first draft, because none of them appears under an obvious heading in profit or loss.
| Item | Treatment in the reconciliation |
|---|---|
| Share of profit of an associate or joint venture | Deduct in full. Dividends actually received are presented separately, in operating or investing activities. |
| Unrealised foreign exchange differences | Reverse. They alter a balance sheet account without a cash movement. |
| Foreign currency translation reserve amounts recycled to profit or loss | Reverse. Recycling on disposal of a foreign operation is a reclassification within equity and profit, never cash. |
| Remeasurement gains and losses | Reverse. Contingent consideration, defined benefit obligations and previously held interests remeasured on acquisition all fall here. |
| Deemed interest on preference shares classified as liabilities | Reverse with other finance costs, then present the amount actually paid. |
| Depreciation arising on fair value adjustments recognised at acquisition | Add back. It is easily missed because it originates in the consolidation, not in the subsidiary's own records. |
| Gain on a bargain purchase | Deduct. The cash effect is the net consideration paid, presented in investing activities. |
The disciplined approach is to work down profit or loss and ask of every line whether it moved cash, and if so, in which activity. Lines that survive both questions untouched are genuine operating cash flows and need no adjustment.
Movements in Working Capital
Working capital adjustments convert accrual revenue and expenses into the amounts settled in cash. The direction follows from whether the balance is an asset or a liability.
| Balance | Increase | Decrease |
|---|---|---|
| Inventories | Deduct — cash was spent on stock not yet expensed | Add — cost of sales exceeded purchases |
| Trade receivables | Deduct — revenue was recognised ahead of collection | Add — collections exceeded revenue |
| Prepayments | Deduct — paid in advance of the expense | Add — the expense exceeded the payment |
| Trade payables | Add — expenses were incurred ahead of payment | Deduct — payments exceeded purchases |
| Accruals | Add — the expense was recognised before settlement | Deduct — settlement exceeded the expense |
| Contract assets | Deduct — revenue recognised without an unconditional right to payment | Add — the right to payment crystallised |
| Contract liabilities | Add — cash received ahead of performance | Deduct — performance caught up with cash already received |
Contract assets and contract liabilities are frequently omitted because they are presented apart from trade receivables. Under IFRS 15 they are working capital in substance, and any interest accruing on a significant financing component within them belongs with finance costs rather than in the working capital movement.
Balance Movements That Are Not Cash
Every working capital adjustment assumes that the change in a balance was caused by cash. Where something else caused it, the movement has to be stripped before it is used. This is the single largest source of a cash flow statement that will not balance, and the causes are predictable.
Capital expenditure sitting in trade payables. An asset bought on credit increases payables without an operating cash flow, and increases property, plant and equipment without an investing cash flow. The unpaid amount must be removed from the payables balance before the working capital movement is calculated, and excluded from capital expenditure.
Interest payable presented within trade and other payables. Interest is presented on its own line, so the interest element has to be carved out of the payables balance at both dates. Otherwise the interest accrual is counted once in the working capital movement and again in interest paid.
Balances acquired or disposed of with a subsidiary. Opening and closing balances that changed because of an acquisition never represent cash flows of the group. The receivables, inventory and payables brought in on acquisition must be excluded from every working capital reconciliation, as the cash effect is presented as a single net line in investing activities. Our guide to consolidated cash flow statements works through this in detail.
Foreign exchange movements on monetary balances. Retranslating a foreign currency payable changes the balance without a payment. Unrealised differences are reversed in the adjustment layer and the corresponding balance movement excluded, as set out in our guide to foreign exchange in cash flow statements.
Amounts written off or utilised against a provision or allowance. These reduce a balance without cash. Where the movement in that balance feeds the reconciliation, the amount written off has to be excluded from it, because no payment was made.
Realised exchange differences on an investing or financing transaction need particular care. Where an asset is purchased for a foreign currency amount and the payment is made later at a different rate, the whole amount actually paid belongs in investing activities. Running that creditor through the ordinary trade payables reconciliation pushes the exchange element into operating activities. Keeping a separate reconciliation for the foreign currency asset creditor prevents it.
Reconstruct the account, do not subtract the balances
For any balance affected by something other than cash, the reliable technique is to write out the account, enter every known non-cash movement, and let cash be the balancing figure. Subtracting opening from closing only works where cash was the sole cause of the change.
Cash Generated from Operations Onwards
The lines presented after the subtotal are not part of the reconciliation. Each is derived by reconstructing its own balance sheet account.
Interest paid. Take the finance cost recognised in profit or loss, add any borrowing costs capitalised to a qualifying asset under IAS 23, and adjust for the movement in interest payable. Capitalised interest is a cash payment even though it never reaches profit or loss, and IAS 7 paragraph 32 requires the total interest paid to be disclosed whether it was expensed or capitalised. Where a lease liability is present, the interest accreted on it has usually been paid within the lease instalment rather than through interest payable.
Income tax paid. Reconstruct the current tax liability: opening balance plus the current tax charge less the closing balance. The current tax charge is the total tax expense less the deferred tax movement recognised in profit or loss. Tax recognised in other comprehensive income is excluded from the charge but included in the liability, so it must be dealt with separately where it exists.
Dividends received. Reconstruct the investment account. For an associate, the dividend is the opening carrying amount plus the share of profit, less the closing carrying amount, adjusted for any share of other comprehensive income.
Dividends paid. Reconstruct retained earnings: opening balance plus profit for the year less the closing balance, adjusted for any transfers to reserves. Dividends declared but unpaid at the reporting date are excluded, and where a dividend payable balance exists it must be reconstructed in the same way.
IAS 7 permits interest and dividends to be classified in more than one section provided the policy is applied consistently. Interest paid may sit in operating or financing activities, interest and dividends received in operating or investing. ASC 230 is more prescriptive: interest paid, interest received and dividends received are all operating, whilst dividends paid are financing.
Investing and Financing Activities
These sections are compiled identically under both methods, from the movement in non-current assets and in funding balances.
Investing cash flows are the amounts actually paid and received. Capital expenditure is derived from the asset roll-forward: opening carrying amount, less depreciation, less the carrying amount of disposals, plus additions, equals the closing carrying amount. Additions are then reduced by any amount unpaid at the reporting date and by any asset recognised without a purchase, such as a right-of-use asset. Proceeds on disposal are the consideration received, not the gain, and the gain has already been reversed in the reconciliation.
Where a subsidiary is acquired, a single net line is presented: the consideration settled in cash, less the cash and cash equivalents held by the subsidiary at acquisition. Deferred or contingent consideration is excluded until it is paid.
Financing cash flows come from the funding balances. Borrowings are reconstructed for new advances and repayments, share capital for issues, and retained earnings for dividends. Leases require the payment to be split, because only the principal element is a financing cash flow.
| Lease event | Presentation |
|---|---|
| Recognition of the right-of-use asset and lease liability at commencement | Non-cash. Excluded from the statement and disclosed as a non-cash transaction. |
| Depreciation of the right-of-use asset | Added back in the operating reconciliation. |
| Interest element of the lease payment | Presented with interest paid, under the entity's interest policy. |
| Principal element of the lease payment | Financing activities. |
| Payments for short-term and low-value leases | Operating activities, as no liability is recognised. |
For a lessor under a finance lease there is no cash flow at commencement, and the capital element recovered through instalments is an investing cash flow rather than a financing one. The mechanics of the liability itself are covered in our guide to calculating the lease liability.
Complete Example
Meridian Ltd reports the following position at 31 December 2026, with comparatives at 31 December 2025.
| Statement of financial position | 2026 | 2025 |
|---|---|---|
| Property, plant and equipment | 1,540,000 | 1,320,000 |
| Right-of-use assets | 300,000 | 200,000 |
| Intangible assets | 210,000 | 240,000 |
| Investment in associate | 395,000 | 360,000 |
| Inventories | 486,000 | 412,000 |
| Trade receivables (gross) | 724,000 | 618,000 |
| Loss allowance | (46,000) | (31,000) |
| Prepayments | 38,000 | 29,000 |
| Cash and cash equivalents | 152,000 | 94,000 |
| Total assets | 3,799,000 | 3,242,000 |
| Share capital | 1,000,000 | 850,000 |
| Retained earnings | 1,236,000 | 958,000 |
| Borrowings | 620,000 | 700,000 |
| Lease liabilities | 284,000 | 195,000 |
| Deferred tax | 132,000 | 118,000 |
| Trade payables | 398,000 | 341,000 |
| Accruals | 54,000 | 41,000 |
| Current tax payable | 75,000 | 39,000 |
| Total equity and liabilities | 3,799,000 | 3,242,000 |
| Statement of profit or loss for the year ended 31 December 2026 | Amount |
|---|---|
| Revenue | 3,420,000 |
| Cost of sales | (1,986,000) |
| Other operating expenses | (742,000) |
| Share of profit of associate | 65,000 |
| Gain on disposal of plant | 22,000 |
| Finance costs | (78,000) |
| Profit before tax | 701,000 |
| Income tax expense | (203,000) |
| Profit for the year | 498,000 |
Additional information:
- Depreciation of property, plant and equipment was 248,000 and depreciation of right-of-use assets was 62,000. Amortisation of intangible assets was 30,000.
- Plant with a carrying amount of 96,000 was sold for 118,000 in cash.
- Additions to property, plant and equipment were 564,000, of which 45,000 remained unpaid at year end and is included in trade payables.
- Leases entered into during the year gave rise to right-of-use assets of 162,000. Interest accreted on lease liabilities was 21,000 and total lease instalments paid were 94,000.
- Amounts written off against the loss allowance were 9,000.
- Accruals include interest payable of 8,000 (2025: 5,000).
- The deferred tax balance moved entirely through profit or loss.
- No borrowings were raised during the year.
Deriving the Figures
The reconstructions below produce every line that is not read straight from the primary statements.
| Figure | Derivation | Amount |
|---|---|---|
| Purchase of property, plant and equipment | Additions of 564,000 less 45,000 unpaid at year end | 519,000 |
| Operating trade payables movement | (398,000 less the 45,000 capital creditor) less 341,000 | 12,000 |
| Operating accruals movement | (54,000 less 8,000 interest) less (41,000 less 5,000 interest) | 10,000 |
| Interest paid | Finance costs of 78,000 less the 21,000 lease element, less the 3,000 increase in interest payable, plus the 21,000 paid within lease instalments | 75,000 |
| Principal element of lease payments | Instalments of 94,000 less the 21,000 interest element | 73,000 |
| Current tax charge | Tax expense of 203,000 less the 14,000 deferred tax movement | 189,000 |
| Income tax paid | 39,000 opening plus 189,000 charge less 75,000 closing | 153,000 |
| Dividends received from associate | 360,000 opening plus 65,000 share of profit less 395,000 closing | 30,000 |
| Dividends paid | 958,000 opening plus 498,000 profit less 1,236,000 closing | 220,000 |
| Repayment of borrowings | 700,000 opening less 620,000 closing, with no new advances | 80,000 |
| Proceeds from issue of shares | 1,000,000 closing less 850,000 opening | 150,000 |
The right-of-use asset movement confirms that no cash flowed on recognition: 200,000 opening, less 62,000 depreciation, plus 162,000 of new leases, gives the 300,000 closing balance without a single cash line.
The Completed Statement
| Statement of cash flows for the year ended 31 December 2026 | Amount |
|---|---|
| Cash flows from operating activities | |
| Profit before tax | 701,000 |
| Adjustments for: | |
| Depreciation of property, plant and equipment | 248,000 |
| Depreciation of right-of-use assets | 62,000 |
| Amortisation of intangible assets | 30,000 |
| Gain on disposal of plant | (22,000) |
| Share of profit of associate | (65,000) |
| Finance costs | 78,000 |
| Operating cash flow before working capital changes | 1,032,000 |
| Changes in working capital: | |
| Increase in inventories | (74,000) |
| Increase in trade receivables | (91,000) |
| Increase in prepayments | (9,000) |
| Increase in trade payables | 12,000 |
| Increase in accruals | 10,000 |
| Cash generated from operations | 880,000 |
| Interest paid | (75,000) |
| Income tax paid | (153,000) |
| Net cash from operating activities | 652,000 |
| Cash flows from investing activities | |
| Purchase of property, plant and equipment | (519,000) |
| Proceeds on disposal of plant | 118,000 |
| Dividends received from associate | 30,000 |
| Net cash used in investing activities | (371,000) |
| Cash flows from financing activities | |
| Proceeds from issue of shares | 150,000 |
| Repayment of borrowings | (80,000) |
| Principal element of lease payments | (73,000) |
| Dividends paid | (220,000) |
| Net cash used in financing activities | (223,000) |
| Net increase in cash and cash equivalents | 58,000 |
| Cash and cash equivalents at the beginning of the year | 94,000 |
| Cash and cash equivalents at the end of the year | 152,000 |
The closing balance agrees with the statement of financial position, which is the only proof that the statement is complete.
Three of the adjustments in this example exist purely because a balance moved for a reason other than cash. The 45,000 capital creditor keeps 45,000 out of both investing activities and the payables movement. The interest payable carve-out keeps 3,000 out of the accruals movement. The 162,000 of new leases keeps the right-of-use asset addition out of investing activities entirely. Omit any one of them and the statement fails to reconcile to the 58,000 movement in cash.
Reconciling to the Direct Method
Both methods must reach the same cash generated from operations. For Meridian Ltd, the direct method arrives at 880,000 from the opposite direction.
| Direct method presentation | Amount |
|---|---|
| Cash receipts from customers | 3,305,000 |
| Cash paid to suppliers and employees | (2,425,000) |
| Cash generated from operations | 880,000 |
Receipts from customers are revenue of 3,420,000 less the 106,000 increase in gross receivables and less the 9,000 written off, giving 3,305,000. Payments follow as the balancing figure, and can be verified independently by reconstructing cost of sales and operating expenses for non-cash charges and the movements in inventories, payables, prepayments and accruals.
The two methods differ in what they cost to prepare and in what they tell a reader. The indirect method explains why profit and cash diverged. The direct method shows the gross flows themselves, which is more useful for forecasting but requires either transactional data or a full reconstruction of each operating balance. Our direct method guide sets out that reconstruction line by line.
Use one as a check on the other
Compiling the operating section both ways is the fastest way to locate an error. The two must agree at cash generated from operations, and the size of any difference usually identifies the omitted adjustment directly.
What IFRS 18 Changes
IFRS 18 makes consequential amendments to IAS 7 that affect the indirect method specifically.
The starting point is fixed. Operating profit becomes the single required subtotal from which the reconciliation begins, replacing the current freedom to start at profit before tax, profit after tax or another figure. Because finance costs, investment income and the share of associate results sit below operating profit, they no longer need reversing, and the adjustment layer shortens accordingly.
The classification options for interest and dividends are removed. In their place are mandatory classifications that depend on whether the entity has specified main business activities, which changes where interest paid, interest received and dividends received are presented. Our guide to the IAS 7 amendments under IFRS 18 sets out the classifications for each type of entity, and our guide to the operating, investing and financing categories covers the subtotal itself.
The reconciliation mechanics are unchanged. Non-cash items are still reversed, working capital movements are still adjusted, and the same balance reconstructions produce interest and tax paid. What changes is where the reconciliation starts and where certain flows are presented.
Disclosure Requirements
Several IAS 7 disclosures apply regardless of which method is used.
| Requirement | Content |
|---|---|
| Components of cash and cash equivalents (paragraph 45) | A reconciliation of the amounts in the statement of cash flows to the equivalent items in the statement of financial position. |
| Non-cash transactions (paragraph 43) | Investing and financing transactions that did not require cash, such as leases recognised in the period, assets acquired on credit and shares issued as consideration. |
| Liabilities arising from financing activities (paragraphs 44A to 44E) | Opening balance, financing cash flows, and separate columns for non-cash changes including new leases, exchange movements, changes in fair value and the effect of obtaining or losing control of subsidiaries, to the closing balance. |
| Interest and tax paid (paragraphs 31 and 35) | Total interest paid during the period, whether expensed or capitalised, and total tax paid, with the classification applied disclosed separately. |
| Acquisitions and disposals of subsidiaries (paragraph 40) | Total consideration, the portion settled in cash, the cash and cash equivalents acquired or disposed of, and the other assets and liabilities by major category. |
| Restricted balances (paragraph 48) | Cash and cash equivalents held by the entity that are not available for use by the group, with commentary. |
The reconciliation of liabilities arising from financing activities is the disclosure most closely tied to the indirect method, because it makes visible the non-cash movements that the statement itself excludes. New leases, exchange differences on foreign currency borrowings and accrued interest all appear there, which is also why it is an effective final check: any financing balance movement not explained by a cash flow must appear in one of its non-cash columns.
IAS 7 paragraphs 22 to 24 also permit certain cash flows to be reported net rather than gross, where they are received or paid on behalf of customers, or where the items turn over quickly and have short maturities, such as borrowings maturing within three months. This applies equally to both methods.
Conclusion
The indirect method reduces to three disciplined steps: choose a profit subtotal and reverse everything in profit or loss that either did not move cash or moved it in another activity, adjust for working capital using movements that cash actually caused, and reconstruct each balance below the subtotal rather than subtracting its opening and closing amounts.
Where a statement fails to reconcile, the cause is almost always in the second step, because a balance moved for a reason the working capital adjustment did not anticipate. Acquisitions, non-cash asset purchases, exchange differences and amounts written off all change balances without cash, and each has to be removed before the movement is used. Our guide to the most common cash flow statement mistakes sets out how to isolate the difference when one arises.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.