How to read a cash flow statement: direct and indirect methods
The cash flow statement explains why profit does not show up in the bank. Its three sections, the two methods and the signals to look for.
The cash flow statement answers a question that the income statement and balance sheet cannot: where did cash come from during the period, and where did it go? Profit is an accounting measure, shaped by accruals, provisions and depreciation that involve no movement of cash. Cash, on the other hand, is either in the bank or it is not. In this article I explain the structure of the cash flow statement, the difference between the direct and indirect methods and what to look for when reading one, using a hypothetical example.
Three sections: operating, investing, financing
IAS 7 (TMS 7 in Türkiye) classifies cash flows into three sections:
- Operating activities: cash flows from the company’s main revenue-producing activities — receipts from customers, payments to suppliers and employees, taxes paid.
- Investing activities: the acquisition and disposal of long-term assets and of investments not treated as cash equivalents — purchases and sales of property, plant and equipment, acquisitions of investees.
- Financing activities: flows that change the size and composition of equity and borrowings — drawing and repaying loans, capital increases, dividend payments.
The split matters because it shows the source of cash. Two companies may end the period with the same increase in cash, but if one generated it from operations and the other by drawing a new loan, their financial health is very different.
The direct and indirect methods
The investing and financing sections look the same under both methods, presented as gross cash receipts and payments. The difference lies in how the operating section is presented:
| Direct method | Indirect method | |
|---|---|---|
| Starting point | Gross cash receipts and payments | Profit for the period |
| Items shown | Receipts from customers, payments to suppliers, payments to staff | Adjustments for non-cash items and working capital changes |
| Strength | Shows clearly where cash came from and went | Explains why profit and cash differ |
| In practice | Less common | Widely used |
IAS 7 permits both methods; in practice the indirect method is more common. For management, reading the two together is valuable: the indirect method answers “why didn’t profit turn into cash?”, and the direct method answers “what level are our receipts and payments running at?”. Weekly cash planning is by nature built on the direct method; a 13-week cash flow forecast is the typical example.
A hypothetical example: reading the indirect method
The company and figures below are entirely hypothetical (TRY million):
| Item | Amount |
|---|---|
| Profit for the period | 20.0 |
| Depreciation | +10.0 |
| Provision expenses | +2.0 |
| Increase in trade receivables | −15.0 |
| Increase in inventories | −5.0 |
| Increase in trade payables | +6.0 |
| Cash flow from operating activities | 18.0 |
| Purchase of property, plant and equipment | −14.0 |
| Sale of property, plant and equipment | +2.0 |
| Cash flow from investing activities | −12.0 |
| Loans drawn | +10.0 |
| Loans repaid | −8.0 |
| Dividends paid | −6.0 |
| Cash flow from financing activities | −4.0 |
| Net change in cash | +2.0 |
The statement tells this story: the company made a profit of TRY 20 million but generated TRY 18 million of cash from operations. Depreciation and provisions are added back because they require no cash outflow; on the other hand, the TRY 15 million rise in receivables shows that a significant part of sales has not yet been collected. The receivables increase is close to three-quarters of profit — a question that must be asked next period. Of the TRY 18 million generated by operations, 12 went to net investment and the remaining 6 was paid out as dividends. Loans drawn exceeded repayments by TRY 2 million, so part of the dividend was indirectly funded by borrowing.
This kind of reading also explains why a profitable company can run short of cash. I discuss that separately in why profitable companies run out of cash.
What the sign combinations suggest
Reading the signs of the three sections together gives a first impression of the company’s situation. The table below is a general reading guide, not a diagnosis, and should always be considered alongside amounts and trends:
| Operating | Investing | Financing | Possible interpretation |
|---|---|---|---|
| + | − | − | Operating cash covers both investment and debt repayment or distributions; a mature, healthy profile |
| + | − | + | Operating cash does not cover investment; growth is supported by additional funding |
| − | − | + | Operations and investment are funded by debt or equity; may signal an early stage or distress |
| − | + | +/− | Selling assets to cover an operating shortfall; sustainability should be questioned |
Five things to watch when reading
- Operating cash relative to profit: if operating cash flow is consistently and markedly below profit over several years, the quality of earnings should be questioned.
- Working capital lines: check whether increases in receivables and inventory are in proportion to sales growth. If sales grow 10% while receivables rise 40%, there may be a collection problem. I explain how to manage these items in how to manage working capital.
- Capital expenditure relative to depreciation: capital expenditure that stays well below depreciation for a long time improves cash in the short term but may indicate an ageing asset base.
- Classification of interest and dividends: the section in which interest and dividends paid and received are shown can differ from company to company. When comparing companies, check in the notes whether the classification is the same.
- Non-cash transactions: assets acquired through leases or debt converted into equity do not appear in the statement because no cash moves; they are disclosed in the notes. Ignoring them can make investment and financing look smaller than they are.
The change coming with IFRS 18
The new presentation standard, IFRS 18, is effective for annual reporting periods beginning on or after 1 January 2027 and also amends IAS 7. Under these amendments, the starting point of the indirect method becomes the “operating profit” subtotal newly defined in the income statement. The amendments also introduce new requirements for classifying interest and dividend cash flows, so a company’s statements before and after transition may not be directly comparable. Anyone doing comparative analysis needs to allow for this during the transition. In Türkiye, how the relevant standards are published by the Public Oversight Authority should be followed separately.
What the cash flow statement does not show
The cash flow statement looks backwards and describes the position at the period-end cut-off. It does not show cash squeezes during the period, obligations about to fall due or unused credit lines. It should therefore be used together with a forward-looking cash forecast and liquidity analysis. I discuss the general limits of financial statements in what financial statements don’t tell us, and how to read liquidity measures in liquidity ratios.
Conclusion
The cash flow statement is the most direct tool for seeing whether profit turns into cash and how a company funds its growth. The indirect method shows why profit and cash differ; the direct method shows the level of receipts and payments. Deducting capital expenditure from operating cash leads to free cash flow, which summarises the company’s real cash-generating capacity. You can read about my work on preparing financial statements and interpreting them for management on the financial reporting page.