In the indirect method, a profit figure is adjusted to cash. Two things need care: the changes in working capital, which move cash up or down depending on the direction of the change, and the alternative, the direct method, which skips profit entirely and lists the cash received and the cash paid. Both give the same net cash from operating activities, and the examiners have asked for each.
This topic covers the working capital adjustments, the complications caused by allowances and write-offs, the direct method with the cash figures worked out from the statement of financial position, and how to prove one method against the other. The next topic covers investing and financing activities.
The direct method is examined directly. In May Diet, 2024, Question 1 asked for a statement of cash flows using the direct method (20 marks), and in November Diet, 2024, Question 4 asked for the statement of cash flows of a company using the direct method (20 marks). Read format and the indirect method first.
In 30 seconds
Working capital in the indirect method: an increase in receivables or inventory reduces cash (deduct); a decrease increases it. An increase in payables increases cash (add); a decrease reduces it.
In the direct method the entity reports the major classes of gross cash receipts and payments:
- cash from customers = revenue + opening receivables − closing receivables
- cash paid to suppliers = purchases + opening payables − closing payables, where purchases = cost of sales + closing inventory − opening inventory
- wages and other expenses paid are the expense adjusted for accruals and prepayments
The net cash is the same by either method. International Accounting Standard (IAS) 7 encourages the direct method.
Working capital adjustments
The change in each working capital item between the opening and closing statements of financial position is the difference between the profit effect and the cash effect.
| Item | Increase | Decrease |
|---|---|---|
| Trade and other receivables | Deduct (cash not yet received) | Add |
| Inventory | Deduct (cash spent on stock not sold) | Add |
| Prepayments | Deduct | Add |
| Trade and other payables | Add (cash not yet paid) | Deduct |
| Accruals | Add | Deduct |
If the question gives only totals for “trade and other receivables” or “trade and other payables”, use them. If it separates items that are not working capital, such as interest payable or tax, they are dealt with separately in the paid figures, not in the working capital adjustment.
Where there is a lack of detail, combine the changes in current assets and current liabilities carefully so that nothing is counted twice.
Allowances and write-offs
Receivables are shown net of an allowance. The cash received depends on the gross figures. If irrecoverable debts were written off, they reduce receivables without any cash coming in. For the indirect method, the change in the allowance is a non-cash charge: either work with the gross receivables or add back the charge for irrecoverable and doubtful debts and use gross movements.
For the direct method, cash from customers = revenue + opening gross receivables − irrecoverable debts written off − closing gross receivables. For example, credit sales are ₦650 million, gross receivables were ₦100 million at the start and ₦118 million at the end, and ₦4 million was written off. Cash from customers is ₦650m + ₦100m − ₦4m − ₦118m = ₦628 million.
The direct method
The direct method shows the major classes of gross cash receipts and gross cash payments from operating activities. IAS 7 encourages it because it gives information that is useful in estimating future cash flows and is not available under the indirect method. The cash figures are derived from the accrual figures:
- Cash received from customers = revenue + opening trade receivables − closing trade receivables.
- Cash paid to suppliers = purchases + opening trade payables − closing trade payables. The purchases figure is cost of sales + closing inventory − opening inventory.
- Cash paid for wages and salaries = expense + opening accrual − closing accrual.
- Cash paid for other expenses = expense + closing prepayment − opening prepayment + opening accrual − closing accrual. Non-cash items such as depreciation and irrecoverable debts are left out.
The net of these is the cash generated from operations; interest, tax and dividends paid follow as in the previous topic.
An example, with proof
A company has revenue of ₦600 million, cost of sales ₦380 million, wages ₦90 million, other expenses ₦55 million and depreciation ₦20 million. Receivables rose from ₦80m to ₦95m, inventory from ₦50m to ₦60m, payables from ₦40m to ₦52m. The wages accrual fell from ₦6m to ₦4m, prepayments of other expenses rose from ₦5m to ₦8m and the accrual on other expenses fell from ₦3m to ₦2m.
- Cash from customers.
₦600m + ₦80m − ₦95m = ₦585m. - Purchases.
₦380m + ₦60m − ₦50m = ₦390m
paid ₦390m + ₦40m − ₦52m = ₦378m. - Wages paid.
₦90m + ₦6m − ₦4m = ₦92m. - Other expenses paid.
₦55m + ₦8m − ₦5m + ₦3m − ₦2m = ₦59m. - Cash generated from operations.
₦585m − ₦378m − ₦92m − ₦59m = ₦56m.
Proof by the indirect method:
- profit before tax ₦600m − ₦380m − ₦90m − ₦55m − ₦20m = ₦55m
- add depreciation ₦20m = ₦75m
- receivables −₦15m
- inventory −₦10m
- payables +₦12m
- wages accrual −₦2m
- prepayments −₦3m
- other accrual −₦1m
- total ₦75m − ₦15m − ₦10m + ₦12m − ₦2m − ₦3m − ₦1m = ₦56m
The two methods agree.
The ideas in more depth
Why the direction of the adjustment is not arbitrary
Profit includes a sale when it is made, but cash arrives later. If receivables grow, more of the sales are still uncollected, so cash is lower than profit suggests. Think of each item as the cash effect of the difference between the accrual figure and the cash figure.
Why prepare both
The direct method gives gross figures that readers can use to forecast. The indirect method shows why cash differs from profit. A proof by the other method checks the arithmetic and is a useful safeguard in the exam.
Sources and references
- IAS 7 Statement of Cash Flows: operating activities, the direct method, and the indirect method.
These points are stated as at 5 November 2026.
Worked examples
Example 1: working capital. Receivables rose by ₦15m, inventory rose by ₦10m and payables rose by ₦12m. Required: the net adjustment.
- Receivables. Increase: −₦15m. Inventory. Increase: −₦10m. Payables. Increase: +₦12m.
- Net.
−₦15m − ₦10m + ₦12m = −₦13m, a reduction in cash.
Example 2: cash paid to suppliers. Cost of sales ₦380m; inventory ₦50m at the start and ₦60m at the end; payables ₦40m and ₦52m. Required: cash paid.
- Purchases.
₦380m + ₦60m − ₦50m = ₦390m. - Cash paid.
₦390m + ₦40m − ₦52m = ₦378m.
Example 3: cash from customers with a write-off. Credit sales ₦650m; gross receivables ₦100m then ₦118m; ₦4m written off. Required: cash received.
- Cash received.
₦650m + ₦100m − ₦4m − ₦118m = ₦628m.
How to answer in the exam
- Set out each cash figure in a working with the opening and closing balances.
- Leave out non-cash items such as depreciation, irrecoverable debts and provisions in the direct method.
- Prove the total by the indirect method if time allows.
- Use the same method for interest, tax and dividends paid as in the previous topic.
Common mistakes in the exam
- Adding an increase in receivables or inventory instead of deducting it.
- Forgetting the purchases step: using cost of sales as the payment to suppliers.
- Including depreciation in the cash paid for expenses.
- Applying the allowance movement as a cash flow.
- Using prepayments and accruals the wrong way round.
- Mixing interest payable and tax payable into the working capital adjustment.
Quick revision
- Receivables, inventory, prepayments: increase deducts. Payables, accruals: increase adds.
- Direct: customers = revenue + opening − closing receivables; suppliers = purchases + opening − closing payables.
- Purchases = cost of sales + closing − opening inventory.
- Direct and indirect give the same cash from operations.
Practice questions
These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.
Recall check: multiple choice
Question 1. An increase in inventory in the indirect method:
- Is added to profit
- Is deducted, because cash was spent on stock not yet sold
- Is ignored
- Is shown in financing
Show the answer
B. It reduces cash.
Question 2. An increase in trade payables:
- Reduces cash
- Is ignored
- Increases cash, because payment is delayed
- Is a financing flow
Show the answer
C. Expenses were incurred but not yet paid.
Question 3. An increase in trade receivables:
- Is deducted from profit
- Is added
- Is ignored
- Is investing
Show the answer
A. More sales are uncollected.
Question 4. The direct method shows:
- Profit adjusted for non-cash items
- Only the net cash figure
- Cash flows from investing only
- The major classes of gross cash receipts and payments
Show the answer
D. IAS 7 encourages it.
Question 5. Cash received from customers equals:
- Revenue only
- Revenue + opening receivables − closing receivables
- Revenue − opening receivables
- Closing receivables
Show the answer
B. Adjusted for any write-offs.
Question 6. Cash paid to suppliers equals:
- Purchases + opening payables − closing payables
- Cost of sales
- Purchases only
- Closing payables
Show the answer
A. Purchases are derived from cost of sales and inventory.
Question 7. Purchases equal:
- Cost of sales
- Revenue
- Cost of sales + closing inventory − opening inventory
- Closing inventory
Show the answer
C. Because cost of sales = opening + purchases − closing.
Question 8. The direct and indirect methods give:
- Different net cash
- Different investing cash
- Different financing cash
- The same net cash from operating activities
Show the answer
D. They differ only in presentation.
Question 9. An increase in prepayments:
- Reduces cash paid
- Is ignored
- Increases the cash paid for expenses
- Is financing
Show the answer
C. Cash was paid for next period.
Question 10. IAS 7 about the direct method:
- Encourages it
- Prohibits it
- Requires it only for banks
- Ignores it
Show the answer
A. Because it gives gross figures useful for forecasting.
Section B style: written questions
Question 11 (10 marks). (a) State how an increase or decrease in each of receivables, inventory and payables is treated in the indirect method. (6 marks) (b) State why IAS 7 encourages the direct method. (4 marks)
Question 12 (15 marks). Revenue is ₦720m; receivables rose from ₦90m to ₦110m. Cost of sales is ₦430m; inventory fell from ₦55m to ₦48m; payables rose from ₦62m to ₦70m. Wages are ₦100m; the accrual rose from ₦5m to ₦8m. (a) Calculate cash received from customers. (4 marks) (b) Calculate cash paid to suppliers. (6 marks) (c) Calculate wages paid. (5 marks)
A further written question
Question 13 (20 marks). Revenue ₦900m; receivables ₦120m rising to ₦135m. Cost of sales ₦560m; inventory ₦70m falling to ₦65m; payables ₦85m rising to ₦92m. Administrative expenses ₦110m; prepayments rose from ₦4m to ₦6m; the accrual fell from ₦3m to ₦2m. Depreciation ₦40m.
(a) Calculate cash generated from operations by the direct method. (10 marks)
(b) Prove it by the indirect method. (8 marks)
(c) State why depreciation is not in the direct method. (2 marks)
Model answers
Show the model answer to Question 11
(a) Receivables: an increase is deducted and a decrease added (2). Inventory: an increase is deducted and a decrease added (2). Payables: an increase is added and a decrease deducted (2).
(b) It shows gross cash receipts and payments by class (2). This information is useful in estimating future cash flows and is not available under the indirect method (2).
Show the model answer to Question 12
(a) ₦720m + ₦90m − ₦110m = ₦700m (4).
(b)
- Purchases ₦430m + ₦48m − ₦55m = ₦423m (3).
- Cash paid ₦423m + ₦62m − ₦70m = ₦415m (3).
(c) ₦100m + ₦5m − ₦8m = ₦97m (5).
Show the model answer to Question 13
(a)
- Cash from customers ₦900m + ₦120m − ₦135m = ₦885m (2).
- Purchases ₦560m + ₦65m − ₦70m = ₦555m (2)
- paid ₦555m + ₦85m − ₦92m = ₦548m (2).
- Administrative expenses paid ₦110m + (₦6m − ₦4m) + (₦3m − ₦2m) = ₦113m (2).
- Cash generated ₦885m − ₦548m − ₦113m = ₦224m (2).
(b)
- Profit before tax ₦900m − ₦560m − ₦110m − ₦40m = ₦190m (2)
- add depreciation ₦40m = ₦230m (1).
- Receivables −₦15m (1); inventory +₦5m (1); payables +₦7m (1); prepayments −₦2m (1); accrual −₦1m (0.5).
- Total ₦224m (0.5).
(c) Depreciation is a non-cash expense, so no cash is paid for it (2).
Pathfinder on IAS 7 (ii): working capital adjustments and the direct method
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Part (a) asks for a statement of cash flows for a company using the direct method (20 marks). Part (b), on profitability and gearing, belongs to the analysis topics.
Revise first: The direct method
The question asks for a statement of cash flows for a company by the direct method from comparative statements and profit or loss figures.
Revise first: The direct method
The statement of cash flows by the indirect method includes working capital adjustments for receivables, inventory and payables.
Revise first: Working capital adjustments
Source: ICAN Pathfinder, Financial Reporting. Diets covered: Every diet in the Pathfinder, from November Diet, 2021 to May Diet, 2026, was reviewed here. The diets listed above test this topic directly..
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