Direct vs indirect method of cash flow: the difference

CFI and CFF are presented identically under both formats. Only CFO's presentation differs. The indirect method, used by the overwhelming majority of companies in every market, starts from accrual profit and un-does the accruals until only cash remains. It only becomes reliable under exam or teardown pressure once you derive the adjustments yourself, properly, one time. Then the signs are theorems you can rebuild, and you never have to trust folklore. Work through this half-page with a pencil. It's the heart of the week.

4.1 Revenue vs collections: the receivables bridge

Revenue is recognized when earned, as the income statement taught you. Cash arrives when customers pay. The gap shows up in accounts receivable. Write the AR T-account as an equation:

AR(end) = AR(begin) + Credit sales − Collections
⇒ Collections = Sales − (AR(end) − AR(begin)) = Sales − ΔAR

If AR rose, some sales are still promises. Collections are smaller than sales, so on the way from profit to cash you subtract the increase in AR. If AR fell, you collected old bills on top of this year's sales, so you add the decrease. Notice that you've just derived the rule instead of memorizing it: an increase in an operating asset consumes cash.

4.2 COGS vs payments: the inventory and payables bridges

Cost of goods sold is recognized when goods are sold. Cash leaves when suppliers are paid, and that's tied to when goods are bought. So you need two bridges:

Purchases = COGS + ΔInventory        (buy more than you sell ⇒ inventory rises)
Payments to suppliers = Purchases − ΔAccounts payable   (pay less than you buy ⇒ payables rise)
⇒ Payments = COGS + ΔInventory − ΔAP

When inventory goes up, you've spent cash the P&L hasn't expensed yet, so subtract. When payables go up, the P&L has expensed things you haven't paid for, so add back. It's the same theorem again, plus its mirror: an increase in an operating liability releases (retains) cash.

4.3 Expenses vs payments: prepaids and accruals

Cash paid for an expense = Expense + ΔPrepaid assets − ΔAccrued liabilities

Prepaid insurance up means you paid ahead of the expense, so subtract. Salaries payable up means the expense is booked but the wages haven't gone out the door yet, so add back. There's no new logic here. Prepaids are operating assets and accruals are operating liabilities.

4.4 Non-cash charges

Depreciation, amortization, impairments, stock-based compensation and, in a US-style presentation, the deferred portion of tax expense all reduce profit but move no cash this period. Add them back. And understand what the add-back means, because half of all beginner errors come from misreading it.

Depreciation isn't "fake", and the add-back isn't a gift. The cash left in the year the asset was bought, and it was reported as capex in that year's CFI. The P&L spreads the old cash cost over the asset's life. The CFS un-spreads it, because the CFS reports each period's actual cash.

SBC is subtler. Shareholders bear its cost as dilution, and the company pays no cash for it. That's why Phase 3's free-cash-flow forecasting work will make you treat it as a real economic cost despite the add-back. Plant the flag now.

4.5 Gains and losses on selling assets: the double-count trap

Sell a machine with book value 20 for 35. Under the income statement's own rules, the P&L shows a gain of 15 inside net income. The actual cash event is 35 of proceeds, and proceeds from selling long-term assets belong in CFI. Leave the 15 in CFO and put 35 in CFI, and the statement would contain 50 of cash from a 35 transaction. So subtract gains from CFO (add back losses), and show the full proceeds in CFI. The gain still counts. It just gets relocated to the section where its cash actually turns up.

4.6 The general recipe

Put 4.1–4.5 together and you get the theorem the whole indirect method rests on:

CFO = Net income
    + non-cash charges (D&A, impairment, SBC, deferred taxes …)
    − gains (+ losses) on non-operating disposals
    − Δ operating assets (AR, inventory, prepaids, contract assets …)
    + Δ operating liabilities (AP, accruals, deferred revenue, provisions …)

Here "Δ" means closing minus opening. And here's the master sign rule you derived, stated once for good:

Operating asset up, cash down. Operating liability up, cash up. Reverse each for decreases.

Which balance-sheet lines count as "operating"? Everything current and operational, except these:

C&CE itself, because it's the answer you're solving for
short-term borrowings and the current portion of long-term debt, which are financing
dividends payable, also financing
current investments, which are investing or cash equivalents
interest accruals, where your standard routes interest outside CFO

When in doubt, ask whether the line exists because you operate the business or because you finance or invest in it.

Here's the full algorithm. You'll drill it until it's automatic:

Start with net income (US style) or profit before tax (Indian style, covered in the presentation-habit note ahead).
Add back non-cash charges.
Remove non-operating items whose cash belongs elsewhere. Gains and losses on disposals are the usual ones. Under an Ind AS presentation you also back out interest and dividend income (their cash goes to CFI) and add back finance costs (their cash goes to CFF).
Apply the sign rule to every operating working-capital delta.
In an Indian presentation, subtract income taxes paid to reach net cash from operating activities.
Build CFI: −capex, −acquisitions, −loans given, +proceeds from disposals/maturities (+interest and dividends received, under Ind AS).
Build CFF: +issues of shares/debt, −buybacks, −principal repayments, −lease principal, −dividends paid (−interest paid, under Ind AS).
Check: CFO + CFI + CFF = ΔC&CE = closing C&CE − opening C&CE. A statement that doesn't tie has something misclassified or missing. Don't skip this as bookkeeping piety. This early in the program, it's the most powerful error-detector you own.

The direct method: awareness and conversion

The direct method presents CFO as the operating cash receipts and payments themselves:

Cash received from customers            870
Cash paid to suppliers                 (513)
Cash paid to employees & for expenses  (187)
Interest paid                           (22)
Income taxes paid                       (33)
Net cash from operating activities      115

Same CFO, different presentation. Indirect reconciles down from profit, and direct builds up from cash. IAS 7 and Ind AS 7 "encourage" direct. US GAAP permits it but also requires the indirect reconciliation as a supplement, so almost no US filer volunteers to prepare both. In India, SEBI's LODR requires the half-yearly CFS by the indirect method, and listed practice is uniformly indirect. What you need is to read indirect fluently and derive direct-method lines on demand. "Cash collected from customers" is a wonderfully concrete number for checking revenue quality, and the earnings-games module ahead leans on it. The conversion formulas are the revenue, COGS and expense bridges built above, run in reverse. The practice set drills them.

Direct vs indirect method of cash flow