Key takeaways
- IAS 7 requires a statement of cash flows classifying cash flows into operating, investing and financing activities.
- Operating cash flows can be presented using the direct method (encouraged) or the indirect method (more common).
- The indirect method reconciles profit to operating cash flow by removing non-cash items and adjusting for working-capital movements.
- IFRS 18 amends IAS 7 from 2027: operating profit becomes the starting point, and choices for classifying interest and dividends are largely removed.
Profit is an accounting measure built on accruals and estimates; cash is what pays salaries, suppliers and lenders. The statement of cash flows, governed by IAS 7 Statement of Cash Flows, shows how an entity generated and used cash during the period. Lenders and credit analysts often read it before the income statement, because it shows whether profits convert into cash and how growth is funded.
1. Cash and cash equivalents
The statement explains the movement in cash and cash equivalents. Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to an insignificant risk of changes in value — typically with a maturity of three months or less from acquisition. Fixed deposits with longer original maturities are usually investments, not cash equivalents. Bank overdrafts repayable on demand that form an integral part of cash management may be included as a component of cash and cash equivalents.
2. Three categories of cash flow
| Category | Definition | Typical examples |
|---|---|---|
| Operating | Principal revenue-producing activities and other activities that are not investing or financing | Receipts from customers; payments to suppliers and employees; income taxes paid (unless specifically identified with investing or financing) |
| Investing | Acquisition and disposal of long-term assets and other investments not included in cash equivalents | Purchase of PPE and intangibles; proceeds from asset sales; purchase or sale of investments; loans made to others |
| Financing | Activities that change the size and composition of equity and borrowings | Share issues; dividends paid (option under current IAS 7); loan drawdowns and repayments; principal portion of lease payments |
3. Direct and indirect methods
Under the direct method, major classes of gross cash receipts and payments are shown — cash received from customers, cash paid to suppliers, cash paid to employees. IAS 7 encourages this method because it provides information that is not available elsewhere. Under the indirect method, profit is adjusted for non-cash items, items classified as investing or financing, and changes in working capital. Most companies use the indirect method because it is easier to prepare from the ledger.
4. Worked example: the indirect method
Swipe sideways to see the full chart →
From profit before tax to operating cash flow — indirect method (illustrative, BDT million)
View the data behind this chart
| Step | Amount | Effect |
|---|---|---|
| Profit before tax | 50 | Starting point |
| Depreciation | +18 | Favourable |
| Finance costs | +6 | Favourable |
| Receivables up | −14 | Adverse |
| Inventories up | −9 | Adverse |
| Payables up | +7 | Favourable |
| Tax paid | −11 | Adverse |
| Operating cash flow | 47 | Result |
Figures are illustrative. In this example finance costs are added back because interest paid is presented within financing activities, and income tax paid is shown separately within operating activities.
The reconciliation reveals the business story behind the numbers. The company is profitable and its operating cash flow is healthy, but BDT 23 million has been absorbed by higher receivables and inventories. If that pattern continues for several periods, it signals collection or stock-building issues worth investigating with the receivables ageing and inventory ageing analyses.
5. Interest, dividends and taxes
Under the current IAS 7, entities have choices. Interest paid and interest and dividends received may be classified as operating, or as financing (interest paid) and investing (interest and dividends received). Dividends paid may be classified as financing or operating. The chosen classification must be applied consistently. Income taxes are classified as operating unless they can be specifically identified with investing or financing activities.
IFRS 18 changes this for annual periods beginning on or after 1 January 2027. For most entities (those without specified main business activities such as banking), interest paid is classified as financing, and interest and dividends received as investing; dividends paid are financing. The indirect method will start from operating profit rather than profit before tax. See my IFRS 18 guide for the wider changes.
6. Non-cash transactions and other disclosures
Investing and financing transactions that do not use cash — acquiring assets under a lease, converting debt to equity, acquiring a business by issuing shares — are excluded from the statement and disclosed elsewhere. IAS 7 also requires a reconciliation of changes in liabilities arising from financing activities, separating cash and non-cash changes (new leases, exchange differences, fair value changes), and, following the 2023 amendment, disclosures about supplier finance arrangements such as reverse factoring — their terms, carrying amounts and payment-date ranges.
Foreign currency cash flows are translated at the rates on the dates of the cash flows, and the effect of exchange rate changes on cash held in foreign currency is shown separately in the reconciliation of cash and cash equivalents (see IAS 21).
7. Reading cash flow quality
- Cash conversion: operating cash flow divided by EBITDA or by profit. Consistently low conversion warrants investigation.
- Free cash flow: operating cash flow less capital expenditure (and lease principal), showing cash available for lenders and shareholders.
- Funding pattern: whether growth and dividends are funded by operations or by new borrowing.
- Working capital trend: repeated large outflows from receivables and inventories.
8. Preparing it reliably
- Start from a reconciled trial balance for the current and prior period.
- Map every balance-sheet movement to operating, investing, financing or non-cash.
- Use subledgers for gross movements: fixed asset additions and disposals, loan drawdowns and repayments, lease additions.
- Exclude non-cash items such as new leases, unrealised exchange differences and provisions.
- Check that the net cash movement equals the change in cash and cash equivalents per the balance sheet.
Standards referenced in this article
IAS and IFRS are one body of standards — IFRS Accounting Standards, issued by the IASB. Standards issued before 2001 keep their IAS numbers and remain fully in force unless replaced. See the full IFRS & IAS standards list for every number and replacement.
| Standard | Title | Status | IFRS # & IAS # link |
|---|---|---|---|
| IFRS 18 | Presentation and Disclosure in Financial Statements | Effective 1 Jan 2027 | Replaces IAS 1 |
| IAS 7 | Statement of Cash Flows | In force (amended by IFRS 18 from 2027) | No IFRS number — IAS 7 is the IFRS standard |
| IAS 21 | The Effects of Changes in Foreign Exchange Rates | In force | No IFRS number — IAS 21 is the IFRS standard |
Frequently asked questions
What is the difference between the direct and indirect method?
The direct method shows gross operating cash receipts and payments, such as cash received from customers and paid to suppliers. The indirect method starts from profit and adjusts for non-cash items and working-capital changes. Both give the same net operating cash flow.
Where are lease payments shown in the cash flow statement?
Under IFRS 16 and IAS 7, the principal portion of lease payments is a financing cash flow. The interest portion follows the entity's policy for interest paid; from 2027, IFRS 18 generally requires interest paid to be classified as financing for most entities. Short-term and low-value lease payments are operating.
Are bank overdrafts part of cash and cash equivalents?
They can be, when they are repayable on demand and form an integral part of the entity's cash management — for example, when the balance often fluctuates between positive and overdrawn.
Conclusion
The statement of cash flows tells the story that profit alone cannot: how much cash operations generate, how much is reinvested and how the business is funded. Classify cash flows carefully, reconcile profit to operating cash with a clear indirect-method bridge, disclose non-cash and financing-liability movements, and prepare for the IFRS 18 changes to interest, dividends and the starting point from 2027.
Written by Liakat Hossain
Finance and accounts professional with experience in FP&A, SAP FICO, Power BI, internal control, reporting, audit, tax, VAT and export-oriented business operations.
This article is original educational content based on professional finance practice. Real-project examples are anonymized, and scenario figures are identified as model outputs rather than guaranteed results.