Cash Flow Statement Indirect Method
The cash flow statement indirect method is an approach to preparing the statement of cash flows, which is one of the main financial statements of a company. The indirect method is more commonly used than the direct method, primarily because it is simpler to prepare and relies on data readily available from the income statement and balance sheet.
In the indirect method, the cash flow from operating activities is calculated by adjusting net income for non-cash items, such as depreciation and amortization, and changes in working capital (i.e., changes in current assets and current liabilities). This method highlights the differences between net income, a company’s accrual-based profitability, and actual cash flow from operations.
The structure of a cash flow statement prepared using the indirect method typically includes the following sections:
- Cash Flows from Operating Activities: Starts with net income and adjusts for non-cash items and changes in working capital to arrive at the net cash flow from operating activities.
- Cash Flows from Investing Activities: Reports cash transactions related to the acquisition or disposal of long-term assets, such as property, plant, and equipment, or investments in other companies.
- Cash Flows from Financing Activities: Summarizes cash inflows and outflows related to the company’s financing activities, such as issuing or repurchasing shares, borrowing or repaying debt, and paying dividends.
- Net Increase (Decrease) in Cash and Cash Equivalents: Shows the overall change in the company’s cash and cash equivalents during the reporting period, calculated as the sum of cash flows from operating, investing, and financing activities.
The indirect method offers a useful reconciliation between the company’s net income and its cash flow from operations, providing valuable insights into the company’s ability to generate cash from its reported earnings.
Example of the Cash Flow Statement Indirect Method
Let’s consider a hypothetical example of a company called TechCo and create a simple cash flow statement using the indirect method for its operating activities during the year. The following financial data is available for TechCo:
Net income: $120,000
Depreciation and amortization: $30,000
Increase in accounts receivable: $20,000
Increase in inventory: $10,000
Increase in accounts payable: $15,000
Decrease in accrued expenses: $5,000
To prepare the cash flow statement using the indirect method, we will start with net income and adjust for non-cash items and changes in working capital:
Cash Flow Statement (Indirect Method) – Operating Activities:
- Net income: $120,000
- Adjustments for non-cash items:
- Depreciation and amortization: $30,000
- Adjustments for changes in working capital:
Net cash flow from operating activities:
= Net income + Non-cash items + Changes in working capital
= $120,000 + $30,000 – $20,000 – $10,000 + $15,000 – $5,000
This simple example demonstrates how the indirect method adjusts net income for non-cash items and changes in working capital to arrive at the net cash flow from operating activities. Keep in mind that a complete cash flow statement would also include sections for investing and financing activities, which are not covered in this example.