Cash Flow Statement Explained: Direct vs Indirect Method
Master the cash flow statement for finance interviews. Learn operating, investing, and financing activities, plus direct vs indirect methods with practice questions.
The Cash Flow Statement shows how a company actually generates and uses cash. It's arguably the most important statement for understanding financial health because cash is harder to manipulate than accounting earnings.
In finance interviews, expect detailed questions about the three sections, working capital adjustments, and why non-cash items are added back. This guide covers everything you need to know, with practice questions to test your understanding.
The Three Sections
Cash Flow Statement Structure
| Term | Definition | Note |
|---|---|---|
| Operating Activities (CFO) | Cash from core business operations | Most important section |
| Investing Activities (CFI) | Cash for long-term investments | Usually negative |
| Financing Activities (CFF) | Cash from debt and equity | Varies by stage |
Cash From Operating Activities
This section shows cash generated from the company's core business. It starts with Net Income and adjusts for non-cash items and working capital changes.
Operating Cash Flow (Indirect Method)
- Net Income (starting point)
- + Depreciation & Amortization (non-cash expense)
- + Stock-Based Compensation (non-cash)
- + Other non-cash charges
- ± Changes in Working Capital
- = Cash From Operations
Working Capital Adjustments
Working Capital Changes
| Term | Definition | Note |
|---|---|---|
| ↑ Accounts Receivable | Cash decreases | Sold but not collected |
| ↑ Inventory | Cash decreases | Bought but not sold |
| ↑ Accounts Payable | Cash increases | Received but not paid |
| ↑ Deferred Revenue | Cash increases | Collected but not earned |
Memory Trick
Current Assets: Increase = Cash outflow (you paid for something)
Current Liabilities: Increase = Cash inflow (you received but didn't pay)
A company's Accounts Receivable increases by $50M and Accounts Payable decreases by $20M. What is the net impact on Cash From Operations?
Cash From Investing Activities
This section covers long-term investments in assets and other companies.
Investing Activities
- - Capital Expenditures (CapEx)
- - Acquisitions
- + Asset sales/divestitures
- - Purchase of investments
- + Sale of investments
- = Cash From Investing
CFI is typically negative for growing companies because they're investing in future growth. Positive CFI might indicate the company is selling assets—which could be a red flag.
Cash From Financing Activities
This section shows cash flows from debt and equity transactions.
Financing Activities
- + Debt issuance
- - Debt repayment
- + Equity issuance
- - Share buybacks
- - Dividends paid
- = Cash From Financing
Why is depreciation added back in the Cash Flow Statement but shown as an expense on the Income Statement?
Direct vs. Indirect Method
Method Comparison
| Aspect | Indirect Method | Direct Method |
|---|---|---|
| Starting Point | Net Income | Cash receipts |
| Approach | Adjust for non-cash items | List actual cash flows |
| Usage | ~95% of companies | Rare in practice |
| Information | Shows reconciliation to NI | Shows actual cash sources |
| Interviews | Focus here | Know conceptually |
The indirect method is standard in practice and interviews. It starts with Net Income and adjusts to get to actual cash—showing the reconciliation between accounting profit and cash generated.
Free Cash Flow
Free Cash Flow (FCF) isn't on the statement but is derived from it. It's the cash available after maintaining/growing the asset base.
FCF = Cash From Operations - CapExThis is the most common definition. Some analysts also subtract dividends.
Unlevered FCF = EBIT × (1-T) + D&A - CapEx - ΔNWCUsed in DCF valuations. Cash available to all capital providers before debt service.
A company has EBITDA of $100M, D&A of $20M, CapEx of $30M, and Net Working Capital increased by $15M. The tax rate is 25%. What is the Unlevered Free Cash Flow?
Classic Interview Questions
Key Takeaways
Key Takeaway
- Three sections: Operating, Investing, Financing
- Indirect method: Start with Net Income, adjust for non-cash and working capital
- D&A added back: Non-cash expense that reduced Net Income
- Working capital: Current asset increase = cash outflow
- Cash is truth: Harder to manipulate than accounting earnings
Related Reading
Continue building your accounting foundation:
- How the 3 Financial Statements Link — See how the CFS connects to the IS and BS
- Depreciation & Amortization Explained — Deep dive into non-cash expenses
- Walk Me Through a DCF — How FCF flows into valuation
- LBO Explained Simply — Why cash flow matters for leveraged buyouts