Level 1 CFA® Exam:
Cash Flow Statement Preparation

Last updated: October 12, 2022

Algorithm of Preparing Cash Flow Statement for Level 1 CFA Candidates

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The algorithm for preparing the cash flow statement is as follows:

  1. Firstly, compute the operating cash flow. Remember to take into account not only the income statement and noncash expenses and revenues but also changes in assets and liabilities such as receivables, inventory, payables, and so on. The operating cash flow can be prepared using either the direct or indirect method.
  2. Secondly, compute investing and financing cash flows. This time only the direct method is allowed.
  3. Finally, compute the cash balance at the end of the period using the cash flows from operating, investing, and financing activities and the cash balance from the beginning of the period.
Lesson Video

Cash Flow from Operations - Indirect Method

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Now, let’s discuss how to create a cash flow from operations using the indirect method. Have a look at the table presenting how to deal with changes in certain asset and liability items.

decrease in inventory add to net income
decrease in receivables add to net income
decrease in prepaid expenses add to net income
increase in payables add to net income
increase in accrued liabilities add to net income
increase in deferred tax liability add to net income
depreciation / amortization / depletion add to net income
amortization of bond discount add to net income
amortization of bond premium subtract from net income
loss on sale of assets add to net income
write-down of assets add to net income

We will discuss some of the items from the table using examples.

Accounts Receivable

When accounts receivable increase in the period, we should subtract the amount by which they increased in the period because it is a sale from which the company didn’t collect cash.

And vice versa: when accounts receivable decrease in the period, we should add the amount by which they decreased in the period because the company received more cash than it results from sales in a given period. Have a look at an example:

Example 1 (cash flow from operations – accounts receivable)

At the end of 2021, accounts receivable for Blacky, Inc. are USD 0. At the end of 2022, they are equal to USD 35,000. If net income is equal to USD 284,000, what is the amount of net income after adjustment resulting from changes in accounts receivable in 2022?

Inventory

Now let’s talk about inventory. When inventory increases in the period, we should subtract the amount by which it increases in the period because if inventory balance increases it means that the company bought more inventory than it sold in a given period and the cost of inventory bought but not sold is not included in the income statement. Have a look at the following example:

Example 2 (cash flow from operations – inventory)

At the end of 2021, inventory for Blacky, Inc. is USD 0. At the end of 2022, it is equal to USD 4,000. What is the value of the adjustment related to changes in the inventory balance?

Accounts Payable

What about the changes in accounts payable? Here if the accounts payable increase in the period, it means that cash paid to suppliers is lower than the value of purchases from suppliers is and vice versa. If the accounts payable decreases in the period, it means that cash paid to suppliers is higher than the value of purchases from them. Have a look at this example.

Example 3 (cash flow from operations – accounts payable)

Accounts payable at the beginning of the year amounted to USD 44,000. The purchases from the suppliers were equal to USD 189,000 and cash paid to suppliers amounted to USD 175,000.

  1. What is the amount of accounts payable at the end of the year?
  2. Is the adjustment to net income while preparing the cash flows from operations a positive or a negative value?

Now have a look at an example of an operating cash flow prepared according to the indirect method. Have a look at the table:

CFO (indirect method) millions of USD
Net income 9,000
Depreciation, depletion & amortization 2,000
Depreciation & depletion 1,500
Amortization of intangible assets 500
Loss on sale of equipment 30
Deferred taxes 12
Changes in working capital (100)
Accounts receivable (800)
Inventory 400
Accounts payable 300
Net operating cash flow 10,942

As you can see we begin with net income, which is at the top of the table, and we adjust it for:

  • non-cash items,
  • non-operating items, and
  • changes in operating accruals.

Cash Flow from Operations - Direct Method

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An example of a cash flow from operations prepared according to the direct method looks as follows:

CFO (direct method) millions of USD
Cash receipts from customers 10
Cash paid to suppliers and employees (2)
Cash paid for other operating expenses (0.5)
Cash generated from operations 7.5
Income tax paid (2)
Cash paid for interest (1)
Net cash from operating activities 4.5

This time we don’t start with net income and adjust it, but we rather present each operating item which results in cash inflows or outflows one by one. These items are cash received from customers, cash paid to suppliers and workers, and so on.

Have a look at an example:

Example 4 (direct method)

In the table, some balance sheet and income statement items of Blacky, Inc. are presented.

2022 (USD, thousands) 2021 (USD, thousands)
Revenue 500 450
COGS 240 160
Operating profit 200 220
Net profit 135 120
Accounts receivable 40 58
Inventory 50 38
Accounts payable 39 35

What is the amount of cash received from customers in 2022 and the amount of cash paid to suppliers in 2022?

Level 1 CFA Exam Takeaways: Cash Flow Statement Preparation

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  1. When preparing cash flow from operations using the indirect method we begin with net income and adjust it for: non-cash items, non-operating items, and changes in operating accruals.
  2. When accounts receivable increase in the period, we should subtract the amount by which they increased in the period because it is a sale from which the company didn’t collect cash.
  3. When inventory increases in the period, we should subtract the amount by which it increases in the period because if inventory balance increases it means that the company bought more inventory than it sold in a given period and the cost of inventory bought but not sold is not included in the income statement.
  4. If the accounts payable increases in the period, it means that cash paid to suppliers is lower than the value of purchases from suppliers.
  5. According to the direct method we present each operating item which results in cash inflows or outflows one by one.