Analyzing Statements of Cash Flows I

Financial Statement Analysis. Worth 11 to 14 percent of the exam. One session: the lesson, the rules, the method, then the questions.

Financial Statement AnalysisAnalyzing Statements of Cash Flows I
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The lesson

Runtime 16 minutes 4 seconds, measured from the published video.

The reading

Five to ten minutes on this one unit: what the exam wants, the idea in plain words, then straight into the trap and the practice.

The exam wants you to classify a described transaction into operating, investing, or financing activities, calculate cash flow from operations under the indirect method, compare the direct and indirect presentations, and describe where IFRS gives a company a choice that US GAAP does not. No calculation here goes beyond adding and subtracting given figures.

Every cash transaction a company makes lands in one of three sections. Operating covers cash from the core business. Investing covers cash from buying or selling long-term assets. Financing covers cash from debt and equity transactions. The indirect method, used by the overwhelming majority of companies, builds cash flow from operations by starting at net income, an accrual number, and reconciling it back to actual cash using the balance sheet's own period-over-period changes. Non-cash charges such as depreciation and amortization are added back first, since they reduced net income without any cash actually leaving the company.

Working capital adjustments follow one rule applied consistently: an increase in a current asset means cash was used or not yet collected, so it is subtracted; an increase in a current liability means the company is effectively being financed by someone else's patience, so it is added. A rise in accounts receivable, for instance, means revenue was recognized but the cash behind it has not arrived yet, so it comes out of operating cash flow even though it looks, on the income statement, like good news. A rise in accounts payable means the company has not yet paid its suppliers, so that cash is still on hand and gets added.

A gain or loss on the sale of an asset needs its own careful handling. The gain already sits inside net income, but the actual cash from the sale belongs entirely in investing activities. Subtracting the gain, or adding back a loss, from operating cash flow and then reporting the full sale proceeds separately under investing is what keeps that gain from being counted twice.

The direct method reports the same total cash flow from operations as the indirect method; the two differ only in presentation, never in the bottom-line result. The direct method lists actual cash receipts and payments, cash collected from customers, cash paid to suppliers and employees, and arrives at the identical CFO figure the indirect method reaches by a different route.

US GAAP fixes the classification of interest and dividends with no flexibility: interest paid, interest received, and dividends received are always operating, and dividends paid are always financing. IFRS gives a company a genuine choice on all four of those same items, interest paid and dividends paid may be classified as operating or financing, interest received and dividends received as operating or investing, provided the company applies its choice consistently from one period to the next. A company reporting under IFRS that classifies dividends paid as an operating outflow, rather than the GAAP-mandated financing outflow, reports a lower operating cash flow than an otherwise identical GAAP company would, purely from that classification choice.

The trap

Assuming a rise in accounts receivable is good news because the company is owed more money ignores that the cash behind that revenue has not actually arrived: rising receivables are a cash outflow in the indirect method, not an inflow, exactly because the sale was made but not yet collected.

What this unit turns on

Read these before the questions, not after them. Everything here traces to this module's own lesson and to the 2026 outline.

The cash flow statement reconciles the income statement's accrual figures to actual cash, using the balance sheet's period-over-period changes

Net income, an accrual number, becomes cash flow from operations once non-cash charges are added back and changes in operating working capital accounts, drawn directly from the balance sheet's beginning and ending balances, are applied; every adjustment in the indirect method traces back to a specific balance sheet line's change over the period.

A current asset increase subtracts from CFO; a current liability increase adds to it

An increase in a current asset such as receivables or inventory means cash was used or not yet collected, so it is subtracted in the indirect method; an increase in a current liability such as payables means the company is being financed by someone else's patience, so it is added. The reverse holds for decreases in either category.

A gain on the sale of an asset is subtracted from CFO because the cash belongs in investing, not operating

A gain (or loss) on disposal already sits inside net income, but the actual cash received from the sale is entirely an investing activity; subtracting the gain (or adding back a loss) in CFO and reporting the full proceeds separately in investing prevents the gain from being counted twice.

The direct and indirect methods report the identical cash flow from operations, only the presentation differs

The direct method lists actual cash receipts and payments, cash collected from customers, cash paid to suppliers and employees, arriving at the same CFO total the indirect method reaches by starting from net income and adjusting; converting from one to the other means rebuilding each direct-method line from its income-statement counterpart plus or minus the related balance sheet change, for example cash collected from customers equals revenue minus an increase (or plus a decrease) in accounts receivable.

IFRS gives a company a choice on interest and dividends that US GAAP does not allow

Under US GAAP, interest paid, interest received, and dividends received are always operating, and dividends paid are always financing, with no flexibility. Under IFRS, all four items may be classified in either of two categories, interest paid and dividends paid as operating or financing, interest received and dividends received as operating or investing, provided the choice is applied consistently period to period.

The trick

Asset up, cash out. Liability up, cash in

The one-line rule for every working capital adjustment in the indirect method. Apply it mechanically to receivables, inventory, and payables and the sign is never in doubt.

GAAP is rigid; IFRS is flexible, on exactly four items

Interest paid, interest received, dividends paid, dividends received. GAAP fixes all four (operating, operating, operating, financing respectively for received-received-paid-received... memorize as: interest paid=operating, interest received=operating, dividends received=operating, dividends paid=financing). IFRS lets the company choose for each of the four, consistently applied.

A gain subtracts, a loss adds, and the full proceeds always go to investing

Removing the gain (or adding back the loss) from CFO and posting the entire sale proceeds to investing is the only way to avoid double-counting the disposal in two sections at once.

The method

The order to work a question of this type in, every time, before you touch the numbers.

  1. Start from net income and identify every non-cash charge (depreciation, amortization, impairment) to add back before touching working capital.
  2. Walk through each operating current asset and current liability account in order, applying asset-up-cash-out, liability-up-cash-in to each change.
  3. Remove any gain or loss on disposal from CFO and route the full cash proceeds to investing activities instead.
  4. If asked to convert to the direct method, rebuild each line (cash from customers, cash to suppliers, cash for operating expenses) from its income statement figure adjusted by the related balance sheet change.
  5. For any interest or dividend classification question, first confirm which accounting standard applies; GAAP has one fixed answer per item, IFRS has two allowed answers per item.

The practice run

Pick an answer, say how sure you are, then reveal. Being sure and wrong is the most useful thing that can happen in a session, so answer honestly: it sends the unit back to learning and puts it at the front of your revision queue.

Question 1Exam level

Under US GAAP, interest paid on long-term debt is most likely classified in the cash flow statement as:

How sure are you?

Correct: A. Under US GAAP (ASC 230), interest paid is ALWAYS classified as an operating activity, regardless of whether the debt is short-term or long-term. This is a hard rule with no flexibility. Candidates are tempted by C because the debt itself (principal) is financing. But the interest cost is operating under GAAP.
B. You might be misled into choosing investing activities because interest paid could be associated with investments or asset acquisitions, but under ASC 230, interest paid is strictly classified as an operating activity, not tied to investing transactions.
C. You might be tempted to choose financing activities because the debt itself is a financing activity, but under US GAAP, interest paid on debt is specifically classified as an operating activity, not a financing activity, because it is considered an expense of running the business.

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Question 2Exam level

A company using the indirect method starts with net income of $500,000. Depreciation expense is $80,000. Accounts receivable increased by $30,000. Inventory decreased by $20,000. Accounts payable decreased by $15,000. Cash flow from operations (CFO) is closest to:

How sure are you?

Correct: A. CFO = Net income + Depreciation - Increase in AR + Decrease in inventory - Decrease in AP = 500,000 + 80,000 - 30,000 + 20,000 - 15,000 = 555,000. Depreciation is added back (non-cash). AR increase means cash collected was less than revenue (subtract). Inventory decrease means less cash tied up in inventory (add). AP decrease means company paid off suppliers faster than it incurred expenses (subtract).
B. You might be tempted to choose $535,000 if you incorrectly subtracted the decrease in inventory instead of adding it, misunderstanding that a decrease in inventory indicates cash was freed up, thus increasing CFO, contrary to the effect of changes in accounts payable and accounts receivable.
C. You might be tempted to choose $595,000 if you incorrectly added the increase in accounts receivable instead of subtracting it, thus violating the rule that an increase in AR indicates cash has not yet been received, so it should reduce CFO.

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Question 3Exam level

Under IFRS, dividends paid by a company can most likely be classified in the statement of cash flows as:

How sure are you?

Correct: C. IAS 7 paragraph 34 explicitly allows dividends paid to be classified as either operating activities (because they are paid out of operating cash) or financing activities (because they are a cost of financial resources). The company must disclose which classification it uses and apply it consistently. Under US GAAP, dividends paid are ALWAYS financing.
A. Choosing A might seem logical if you think dividends are always paid from operating cash flows, but IAS 7 paragraph 34 gives companies the flexibility to classify dividends paid as either operating or financing activities, which contradicts the exclusivity suggested by A.
B. Choosing B might seem logical if you think dividends are strictly a cost of financial resources, but IAS 7 paragraph 34 provides flexibility to classify dividends as either operating or financing activities, depending on the company's approach to cash flow reporting.

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Question 4Exam level

Which of the following is most likely classified as an investing activity in the cash flow statement?

How sure are you?

Correct: B. The purchase of property, plant, and equipment (capital expenditures) is always an investing activity. Both under IFRS and US GAAP. Investing activities cover acquisition and disposal of long-term assets and investments in other entities.
A. You might be tempted to choose A because paying dividends involves a significant cash outflow, which can seem like an investing activity. However, dividends are payments to shareholders and are classified as financing activities, not investing activities, as they relate to the company's financing structure rather than its investments in assets.
C. You might be tempted to choose repayment of a bank loan principal as an investing activity because it involves a significant cash outflow, but this is actually a financing activity as it relates to the company's debt management, unlike the purchase of a factory building which is an investment in long-term assets.

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Question 5Exam level

A firm reports net income of $200,000. It has $40,000 of depreciation, a $25,000 gain on sale of equipment, and a $10,000 increase in accrued liabilities. Under the indirect method, CFO is closest to:

How sure are you?

Correct: A. CFO = 200,000 + 40,000 (add back depreciation, non-cash) - 25,000 (subtract gain on sale of equipment. The proceeds go to investing, not operating) + 10,000 (accrued liabilities increase = operating cash inflow) = 225,000. The gain on sale must be removed from CFO because the full proceeds from the equipment sale appear in investing activities. If you leave the gain in CFO AND count the sale proceeds in investing, you double-count.
B. Choosing $275,000 might tempt you to add the gain on sale of equipment to net income, but this violates the rule that gains from asset sales must be subtracted under the indirect method to avoid double-counting the cash proceeds in both operating and investing activities.
C. Choosing $205,000 might seem right if you only add back depreciation and ignore the impact of the gain on sale of equipment and the increase in accrued liabilities, but this overlooks the need to adjust for non-cash items and changes in working capital, leading to an underestimation of CFO.

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Question 6Exam level

Free cash flow to the firm (FCFF) is most likely described as:

How sure are you?

Correct: B. FCFF = CFO - Capital Expenditures (net of proceeds from asset sales). This is the simplest and most testable definition. CFO already reflects the after-tax nature of cash flows and working capital changes. Capital expenditures (capex) represent the reinvestment needed to maintain/grow the business. FCFF represents cash available to ALL capital providers (debt + equity) after reinvestment.
A. Choosing net income minus capital expenditures might seem logical if you associate net income with the firm's total earnings, but this option overlooks the fact that net income includes non-cash items and does not directly account for changes in working capital, making it an incomplete measure of cash available to all capital providers.
C. You might be tempted by choice C because it includes EBIT, which is a common starting point for cash flow calculations, but this choice incorrectly assumes EBIT directly translates to cash flow without adjusting for taxes and working capital changes, unlike CFO which already accounts for these adjustments.

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Question 7Harder

Under IFRS, interest received from loans made to other parties is most likely classified in the cash flow statement as:

How sure are you?

Correct: B. IAS 7 allows interest RECEIVED to be classified as either operating (because it enters the determination of profit) or investing (because it is a return on investments). Under US GAAP (ASC 230), interest received is ALWAYS operating. This IFRS flexibility is a frequent exam differentiator.
A. Choosing A might seem logical if you assume all income related to profit is operating, but IAS 7 explicitly permits classifying interest received from loans as investing activities if it is viewed as a return on investments, not just operating activities.
C. Choosing C might seem logical if you think interest received is always tied to investment returns, but IAS 7 explicitly permits classifying interest received as operating activities because it is part of the profit determination process, not exclusively as an investing activity.

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Question 8Exam level

A company issues $5 million in common stock and simultaneously uses $3 million to purchase equipment. How should these be reported in the cash flow statement, most likely?

How sure are you?

Correct: B. Cash transactions must be shown GROSS (not netted) in the statement of cash flows. The $5 million stock issuance is a financing inflow. The $3 million equipment purchase is an investing outflow. They are reported separately because the underlying transactions are substantively different activities. Netting is prohibited for significant transactions.
A. Choosing A might seem logical if you think netting cash flows simplifies reporting, but it violates the requirement to show cash transactions gross in the statement of cash flows, failing to distinguish between the financing inflow and the investing outflow as separate activities.
C. Choosing C might seem logical if you think all transactions involving equipment purchases are non-cash disclosures, but this violates the rule that actual cash inflows and outflows must be reported in their respective sections of the cash flow statement, not just disclosed as non-cash items.

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Question 9Exam level

Compared to the indirect method, the direct method of presenting operating cash flows, most likely:

How sure are you?

Correct: B. The direct and indirect methods are two different PRESENTATIONS of the same underlying CFO number. Direct method shows actual cash inflows (cash collected from customers) and outflows (cash paid to suppliers, employees, etc.) in operating activities. The indirect method reconciles net income to CFO. BOTH methods arrive at the identical CFO figure. The choice of method is a disclosure choice only.
A. You might be tempted to think that showing actual cash receipts would naturally lead to a higher CFO, but this overlooks the fact that both methods calculate the same CFO; the direct method simply presents cash flows in a more straightforward, receipts and payments format rather than adjusting net income.
C. You might think that IFRS mandates the direct method while US GAAP allows flexibility, but in reality, both IFRS and US GAAP permit the use of either the direct or indirect method for presenting operating cash flows, meaning choice C confuses the flexibility allowed under both standards with a requirement.

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Question 10Exam level

A company has the following data: CFO = $800,000; Capital expenditures = $300,000; Proceeds from sale of equipment = $50,000; Net borrowings = $200,000. FCFF is closest to:

How sure are you?

Correct: B. FCFF = CFO - Net capital expenditures = CFO - (Gross capex - proceeds from asset sales) = 800,000 - (300,000 - 50,000) = 800,000 - 250,000 = 550,000. Net borrowings do not enter the FCFF calculation because FCFF represents cash available to ALL capital providers before any financing decisions. Net borrowings would be used in the FCFE formula.
A. You might be tempted to subtract the gross capital expenditures from CFO without adding back the proceeds from the sale of equipment, leading to $500,000, but this approach overlooks the rule that proceeds from asset sales should be added back to CFO before subtracting net capital expenditures, which is why $500,000 is incorrect.
C. Choosing $750,000 might tempt you if you mistakenly add the proceeds from the sale of equipment to CFO before subtracting capital expenditures, but this approach overlooks the proper adjustment for net capital spending, which should only subtract the gross capital expenditures adjusted by the proceeds, leading to an incorrect FCFF value.

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Question 11Exam level

Which of the following items would a company report as a SUPPLEMENTAL disclosure to its statement of cash flows rather than within the main body, most likely?

How sure are you?

Correct: B. When a company acquires an asset by issuing shares directly to the seller, with no cash changing hands, there is no cash flow to report in the body of the statement. However, the transaction is significant and must be disclosed in a supplemental schedule of non-cash investing and financing activities. IFRS and US GAAP both require this supplemental disclosure for material non-cash transactions.
A. You might be tempted to choose depreciation expense added back to net income because it involves a non-cash adjustment, but depreciation is already accounted for in the operating activities section of the cash flow statement, not as a supplemental disclosure like non-cash transactions in investing and financing activities.
C. You might think dividends paid to common shareholders do not involve cash, but dividends are actual cash outflows and are reported in the financing activities section, not as a supplemental disclosure like non-cash transactions.

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Question 12Harder

An analyst observes that a firm's CFO has been consistently lower than net income for three consecutive years. This pattern most likely indicates:

How sure are you?

Correct: B. When CFO persistently trails net income, it means the company is reporting profits that are not converting to cash. This is a classic red flag for earnings management. The accrual component of earnings (net income minus CFO) is rising, which historically predicts earnings reversals. High-quality earnings are characterized by CFO being close to or exceeding net income. Persistent divergence warrants scrutiny of revenue recognition and expense timing.
A. You might think that rapid growth and heavy capital investment would explain the CFO being lower than net income, but this overlooks the fact that such investments typically show up as capital expenditures, not as a discrepancy between net income and CFO. This choice confuses the impact of capital spending with the accruals building up, which is more indicative of potential earnings quality issues.
C. You might be misled into thinking that low CFO relative to net income indicates cash is being paid out as dividends, but dividends do not affect the relationship between CFO and net income directly; instead, a persistent CFO lower than net income suggests accruals are building up, indicating potential earnings quality issues.

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Question 13Above the exam

A company reports net income of $500,000. During the year, accounts receivable increased $40,000, inventory decreased $25,000, accounts payable decreased $15,000, and depreciation expense was $60,000. The company also purchased equipment for $200,000 cash. Combining the indirect-method CFO reconciliation with the correct classification of the equipment purchase, cash flow from operations is closest to:

How sure are you?

Correct: B. Starting from net income and adjusting only OPERATING items: $500,000 + $60,000 (depreciation, a non-cash add-back) - $40,000 (AR increase, a use of cash) + $25,000 (inventory decrease, a source of cash) - $15,000 (AP decrease, a use of cash) = $530,000. The $200,000 equipment purchase is a cash flow from INVESTING activities, not operating, and must not be subtracted from CFO.
A. $330,000 incorrectly subtracts the $200,000 equipment purchase from operating cash flow; purchasing equipment is an investing activity, and mixing it into the CFO reconciliation is exactly the classification error this LOS is designed to catch.
C. $730,000 treats the $200,000 equipment purchase as an ADDITION to operating cash flow instead of correctly excluding it entirely from CFO (and instead placing it, as a subtraction, in investing cash flow); a cash outflow for a fixed asset never belongs in the operating section under the indirect method.

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Question 14Above the exam

A company using the indirect method reports an increase in deferred tax liabilities of $30,000 during the year and also reports a gain on the sale of equipment of $10,000 within net income. Combining the treatment of non-cash items with the treatment of investing-related gains in the CFO reconciliation, the correct indirect-method adjustments to net income are most likely to:

How sure are you?

Correct: B. An increase in deferred tax liabilities is a non-cash operating adjustment and is ADDED BACK to net income under the indirect method (net income was reduced by tax expense that was not actually paid in cash yet). A gain on the sale of equipment, by contrast, is an INVESTING-related item that inflated net income; it must be SUBTRACTED out of the CFO reconciliation so the full cash proceeds from the sale can be reported, correctly, within investing activities instead, avoiding double-counting the gain in both sections.
A. Both being 'non-cash' does not mean both are treated the same way; the deferred tax item is a genuine non-cash OPERATING adjustment (add back), while the gain on sale is a non-cash item that belongs entirely in INVESTING activities and must be removed (subtracted) from the operating section, not added back.
C. Subtracting the deferred tax liability increase reverses the correct treatment; an increase in a deferred tax LIABILITY is a source of cash from an operating standpoint (tax expensed but not yet paid) and should be added back, not subtracted.

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