The statement of cash flows: indirect and direct methods

Profit depends on judgements; cash does not. A Nigerian company can report a healthy profit and still fail to pay salaries at the end of the month, because its cash is tied up in inventory, in customers who have not paid, or in a new factory. The statement of cash flows shows where cash came from and where it went. ICAN asks you to prepare it under IAS 7 Statement of Cash Flows from two statements of financial position, a statement of profit or loss and some notes, by the indirect method, the direct method or both, and sometimes to comment on what it shows. The method is mechanical once learned, and it checks itself: the statement must end at the actual closing cash.

Cash and cash equivalents

The statement explains the change in cash and cash equivalents. Cash is cash in hand and deposits repayable on demand. Cash equivalents are short-term, highly liquid investments that convert readily into a known amount of cash with an insignificant risk of a change in value; as a rule, those maturing within three months of acquisition, such as a 90-day fixed deposit. Equity shares are not cash equivalents. A bank overdraft repayable on demand that forms part of day-to-day cash management is deducted within cash and cash equivalents. The notes show the components and reconcile them to the statement of financial position.

The three headings

IAS 7 lets a company choose where interest and dividends go, applied consistently from year to year:

The most common presentation, and the one used in IAS 7's own illustration, is interest paid in operating activities, interest and dividends received in investing activities, and dividends paid in financing activities. Follow the question if it states a policy.

The indirect method

The indirect method starts from profit and removes everything that is not an operating cash flow. Under the IAS 1 format, start from profit before tax:

1. Add back finance costs and deduct investment income, because interest and dividends appear as cash flows of their own.
2. Add back non-cash expenses (depreciation, amortisation, impairment, losses on disposal, increases in provisions) and deduct non-cash income (gains on disposal, fair value gains on investment property).
3. Adjust for working capital: deduct an increase in inventories, receivables or prepayments; add a decrease. Add an increase in payables or accruals; deduct a decrease.
4. The result is cash generated from operations. Deduct interest paid (under the common presentation) and income taxes paid to reach net cash from operating activities.

The direct method

The direct method lists the actual operating receipts and payments instead of reconciling from profit. IAS 7 encourages it because it shows real cash flows, and ICAN does set it. The workings:

• Cash received from customers = opening receivables + revenue − closing receivables.
• Purchases = cost of materials in cost of sales + closing inventory − opening inventory.
• Cash paid to suppliers = opening payables + purchases − closing payables.
• Cash paid to employees = employee costs + opening wages accrual − closing accrual.
• Cash paid for other expenses = other cash expenses + closing prepayments − opening prepayments (or less the increase in accruals).

Depreciation and disposal losses never appear in the direct method: they are not cash. Both methods give the same cash generated from operations, and the rest of the statement is identical.

Finding the figures you cannot read off

Each missing cash flow is the balancing figure in a small account: opening balance, add what increased it, deduct what reduced it, and the gap to the closing balance is the cash.

Revaluations, bonus issues and assets acquired without cash (for example in exchange for shares) are non-cash transactions: they explain movements but never appear in the statement. IAS 7 requires them to be disclosed elsewhere in the financial statements. It also requires a reconciliation of the opening and closing liabilities arising from financing activities, such as loans, split between cash and non-cash changes.

Worked example

Oyelaran Plastics Plc, a fictional manufacturer of plastic containers, has the following figures.

Notes:

1. Cost of sales and expenses comprise raw materials consumed ₦1,500m, employee costs ₦620m, depreciation ₦150m, loss on disposal of plant ₦12m and other operating expenses ₦388m (total ₦2,670m).
2. Plant with a carrying amount of ₦40m was sold during the year. Land was revalued upwards by ₦80m at 31 December 2026 (ignore deferred tax on it).
3. On 1 March 2026 the company made a 1 for 10 bonus issue out of retained earnings. On 1 September 2026 it issued 100m shares for cash at ₦1.50 each.
4. ₦100m of loan notes were repaid at par on 30 June 2026.
5. Investment income was received in cash. All raw materials are bought on credit; wages are paid in the month; other expenses are paid in cash, subject to the prepayments shown. A dividend was paid during the year.

Workings (₦m)

The bonus issue was 1,000m shares (₦500m ÷ ₦0.50) × 1/10 = 100m shares, ₦50m at nominal value, taken from retained earnings. The cash issue checks: 100m shares × ₦1.50 = ₦150m. Finance costs also check: ₦400m × 12% × 6/12 + ₦300m × 12% × 6/12 = ₦24m + ₦18m = ₦42m.

Oyelaran Plastics Plc: statement of cash flows for the year ended 31 December 2026 (indirect method)

It reconciles: ₦527m − ₦456m − ₦25m = ₦46m, and ₦40m + ₦46m = ₦86m, the closing cash in the statement of financial position. The revaluation and the bonus issue appear nowhere: no cash moved. The note on financing liabilities shows loan notes of ₦400m at 1 January, a cash repayment of ₦100m and ₦300m at 31 December.

The direct method. Purchases = materials ₦1,500m + closing inventory ₦410m − opening inventory ₦360m = ₦1,550m.

Both methods give ₦687m. The investing and financing sections are the same as above.

What it tells a user. Operations generated ₦687m, enough to pay interest, tax and the dividend and fund most of the ₦490m of new plant. The share issue paid for the loan repayment. That is a company investing for growth from its own cash, with borrowing falling.

Under IFRS 18

For years beginning on or after 1 January 2027, IAS 7 as amended by IFRS 18 starts the indirect method at operating profit and fixes the headings: interest paid and dividends paid are financing, and interest and dividends received are investing. Oyelaran's operating profit would be ₦1,120m − ₦260m − ₦330m = ₦530m (investment income is investing, finance costs financing).

The net increase is still ₦46m; only the headings moved. Follow any notice from ICAN on which basis a diet expects.

Common mistakes

• Putting the loss or gain on disposal in investing activities: the adjustment belongs in operating, the proceeds in investing.
• Reversing working capital signs: an increase in receivables or inventories reduces cash; an increase in payables increases it.
• Forgetting the revaluation or the disposal in the PPE working, so that purchases are wrong.
• Treating a bonus issue as cash from a share issue, or forgetting that a bonus issue from retained earnings must be removed before the dividends paid working.
• Using only current tax in the tax working when the charge includes deferred tax.
• Adding back depreciation in the direct method.

Exam technique

Before calculating, go down both statements of financial position and mark where each movement belongs: working capital to operating, non-current assets to investing, equity and loans to financing. Then do the workings as small labelled accounts, and only then write the statement. Say which classification you use for interest and dividends. Finish with the reconciliation to closing cash: if it does not agree, look for a missed movement or a wrong sign before redoing anything. If asked to comment, use the statement: whether operating cash covers interest, tax, dividends and capital spending, and how any gap was financed.

Study with AI

I am studying ICAN Financial Reporting (FR): the statement of cash flows under
IAS 7. Give me two statements of financial position and a statement of profit or
loss in naira for a fictional Nigerian company, with a disposal at a loss, a
revaluation, a bonus issue and a cash share issue, a loan repayment, tax and
dividends. Let me prepare the statement by the indirect and direct methods, then
check each working and confirm that it reconciles to closing cash.

AI assistants can make arithmetic slips and mix up the IAS 7 choices with IFRS 18's fixed headings: check every answer against these notes.

Lecturer's note: Every figure in a statement of cash flows answers one question: how much cash actually moved? When the cash is not given, find it the same way every time: write the opening balance, add whatever increased the account, deduct whatever reduced it other than cash, and the gap to the closing balance is the cash. Purchases of plant, tax paid, interest paid and dividends paid are all that same little account. Learn the pattern once and you can find any figure the examiner hides.

Key points

• The statement explains the change in cash and cash equivalents under three headings: operating, investing and financing.
• Under IAS 7 now, interest and dividends may be classified in more than one heading; apply the choice consistently and follow the question.
• The indirect method starts from profit before tax, adds back finance costs and non-cash items, removes investment income and adjusts for working capital.
• The direct method lists receipts from customers and payments to suppliers, employees and others, and reaches the same cash generated from operations.
• Purchases, proceeds, tax, interest, dividends and share proceeds are balancing figures; non-cash transactions are disclosed, not included.
• Under IFRS 18 the indirect method starts from operating profit, and interest and dividends paid are financing, received investing.

Quick check

1. Opening current tax ₦30m and deferred tax ₦50m; closing current tax ₦38m and deferred tax ₦56m; tax charge ₦45m. How much tax was paid?
2. Opening receivables ₦120m, closing ₦145m, revenue ₦1,600m. How much cash was received from customers?
3. Share capital rose from ₦200m to ₦300m and share premium from ₦80m to ₦110m. ₦40m of the increase in share capital was a bonus issue from share premium. What was the cash from shares issued?

Answers

1. (₦30m + ₦50m) + ₦45m − (₦38m + ₦56m) = ₦31m.
2. ₦120m + ₦1,600m − ₦145m = ₦1,575m.
3. Combined capital and premium rose by (₦300m + ₦110m) − (₦200m + ₦80m) = ₦130m. A bonus issue from share premium moves an amount within that total, so the cash raised is ₦130m.