The direct method lists the actual cash a business received and paid from its operations: cash from customers, cash to suppliers, cash for wages. The indirect method starts from net income and adjusts it back to cash. Both methods give the same net cash from operating activities. They only show the route differently.
The choice only affects the operating section of the cash flow statement. Investing and financing activities look the same whichever method you use. This guide works through one company both ways, so you can see exactly where each number comes from.
Direct vs indirect at a glance
| Direct method | Indirect method | |
|---|---|---|
| Starting point | Cash receipts and payments | Net income (profit) |
| What it shows | Where operating cash came from and went | Why profit and operating cash differ |
| Depreciation | Never appears; it is not a cash flow | Added back to net income |
| Working capital changes | Built into each receipt and payment | Shown as separate adjustments |
| Ease of preparation | Harder; needs gross cash figures | Easier; uses the income statement and balance sheet |
| Standard setters' view | Encouraged by IAS 7 and preferred by the FASB | Allowed, and used by most companies |
| Extra disclosure | US GAAP also requires an indirect reconciliation | None needed |
The data: Fernhill Supplies
Fernhill Supplies has this income statement for 2026:
| $ | |
|---|---|
| Revenue | 186,000 |
| Cost of goods sold | (102,000) |
| Wages | (40,000) |
| Other operating expenses | (6,000) |
| Depreciation | (10,000) |
| Net income | 28,000 |
During the year, accounts receivable rose by $6,000, inventory fell by $4,000, accounts payable rose by $3,000, and accrued expenses fell by $6,000.
The direct method
Take each income statement line and convert it to cash by adjusting for the related balance sheet account.
| Operating activities | Working | $ |
|---|---|---|
| Cash received from customers | 186,000 − 6,000 increase in receivables | 180,000 |
| Cash paid to suppliers | 102,000 − 4,000 inventory decrease − 3,000 payables increase | (95,000) |
| Cash paid for wages | No wages accrual | (40,000) |
| Cash paid for other expenses | 6,000 + 6,000 decrease in accruals | (12,000) |
| Net cash from operating activities | 33,000 |
Each adjustment makes sense in plain words. Receivables went up, so customers paid $6,000 less than the sales recorded. Payables went up, so Fernhill paid suppliers $3,000 less than it bought. Accruals went down, so it paid off $6,000 of last year's bills on top of this year's expense. Depreciation does not appear at all, because no cash left the business for it.
The indirect method
Start from net income and remove everything that is not cash.
| Operating activities | $ |
|---|---|
| Net income | 28,000 |
| Add: depreciation | 10,000 |
| Less: increase in accounts receivable | (6,000) |
| Add: decrease in inventory | 4,000 |
| Add: increase in accounts payable | 3,000 |
| Less: decrease in accrued expenses | (6,000) |
| Net cash from operating activities | 33,000 |
The answer is the same $33,000. The two methods are two ways of reaching the same number.
The working capital rule
Most indirect-method errors come from getting the signs on working capital the wrong way round. One rule covers all of them:
- Current assets (receivables, inventory, prepayments): an increase is subtracted, a decrease is added. More money tied up in assets means less cash.
- Current liabilities (payables, accruals): an increase is added, a decrease is subtracted. Owing more means you have held on to cash.
If you are unsure, imagine a single extreme case: if receivables rose by your entire revenue, no customer paid, and you would have collected nothing. So an increase in receivables has to reduce cash.
Why depreciation is added back
Depreciation is not a source of cash, even though it is "added". It was deducted when net income was calculated, but no cash was paid for it in the year; the cash went out when the asset was bought, and that purchase sits in investing activities. Adding it back simply reverses a deduction that never involved cash. The same applies to amortization, impairment losses and losses on disposal. Gains on disposal are subtracted, because the cash from the sale is already shown in investing activities.
Why most companies use the indirect method
IAS 7 encourages the direct method, and the FASB prefers it, because it tells readers more about where cash actually came from. In practice, almost every company still uses the indirect method. It can be prepared from the income statement and two balance sheets, while the direct method needs gross cash receipts and payments that many accounting systems do not track separately.
US GAAP adds a twist: a company that uses the direct method must also disclose the indirect reconciliation, so it effectively prepares both. That removes much of the incentive to choose direct.
Interest and dividends: an IFRS and US GAAP difference
Under US GAAP, interest paid, interest received and dividends received are operating cash flows, and dividends paid are financing. IAS 7 has historically allowed a choice, applied consistently. IFRS 18, effective for annual periods from January 1, 2027, removes most of that choice: for most companies, interest and dividends received will be investing cash flows, and interest and dividends paid will be financing. Check which rules your course or exam follows.
Common mistakes
- Reversing the working capital signs. Use the rule above rather than memorizing each account.
- Including depreciation in the direct method. It belongs only in the indirect reconciliation.
- Leaving a gain on disposal in operating cash flow. Subtract it; the sale proceeds go in investing.
- Treating non-cash transactions as cash flows. Buying equipment with a loan, or converting debt into shares, is disclosed in a note and never appears in the statement itself.
Which method should you learn first?
Learn the indirect method first. It is what you will see in most published accounts and most exam questions. Then learn the direct method, because some exams still ask for it and it makes the logic of "where did the cash go" much more intuitive. For the wider statement, see IAS 7 statement of cash flows, and for how cash differs from profit, see income statement vs cash flow statement.
Practice both methods
The cash flow statement has more moving parts than any other statement: working capital, non-cash items and classification all at once. Accountely's cash flow statement challenges cover both methods and check each line separately, so you can see exactly where a reconciliation went wrong. There are dedicated indirect method and direct method sets, and it's free to start.
Frequently Asked Questions
What is the difference between the direct and indirect cash flow methods?
The direct method reports operating cash flows as gross receipts and payments, such as cash from customers and cash paid to suppliers. The indirect method starts with net income and adjusts for non-cash items and changes in working capital. Both give the same net cash from operating activities.
Do the direct and indirect methods give the same answer?
Yes. Net cash from operating activities is identical under both. Only the presentation of the operating section differs; investing and financing sections are the same.
Which cash flow method is required?
Neither is required under IFRS or US GAAP. Both standard setters encourage the direct method, but most companies use the indirect method because it is easier to prepare. Under US GAAP, a company using the direct method must also show the indirect reconciliation.
Why is depreciation added back in the indirect method?
Depreciation reduced net income but involved no cash payment in the year. Adding it back removes a non-cash expense so the figure moves from profit to cash. It is not a source of cash.