What is the Indirect Method?
The indirect method transforms net income into cash flow from operating activities by adjusting for non-cash transactions and changes in working capital. It bridges the gap between accrual accounting—where revenues and expenses are recorded when earned or incurred—and actual cash movements. This approach reveals how profits convert into cash, offering insight into operational efficiency.
At its core, the indirect method starts with net income and adds back non-cash expenses like depreciation and amortization, since these reduce profit but don't involve cash outflows. The indirect method then adjusts for changes in current assets and liabilities:
- Increases in accounts receivable or inventory consume cash
- Increases in accounts payable or accrued expenses provide cash.
These adjustments align reported earnings with cash generated.
Understanding this method is crucial because net income alone doesn't reflect cash availability. A company might show a profit but have cash shortages due to high receivables or inventory levels. The indirect method highlights these discrepancies, helping assess liquidity and manage working capital effectively.
By focusing on the reconciliation between net income and cash flow, the indirect method provides a high-level view without delving into every cash transaction. It's favored for its simplicity and the comprehensive perspective it offers on how operating activities impact a company's cash position.
Examples of the Indirect Method
# Let's say a company has:
Net income: 200,000
Depreciation expense: 50,000
Increase in accounts receivable: 30,000
Decrease in inventory: 20,000
Increase in accounts aayable: 10,000
# Calculating cash flow from operating activities:
1. Start with net income: 200,000
2. Add back depreciation: 200,000 + 50,000 = 250,000
3. Adjust for changes in working capital:
- Accounts receivable increase: 250,000 - 30,000 = 220,000
- Inventory decrease: 220,000 + 20,000 = 240,000
- Accounts payable increase: 240,000 + 10,000 = 250,000
Net cash provided by operating activities: 250,000# Another company reports:
Net income: 150,000
Amortization expense: 25,000
Decrease in prepaid expenses: 5,000
Decrease in pccrued expenses: 15,000
#Calculating cash flow from operating activities:
1. Start with net income: 150,000
2. Add back amortization: 150,000 + 25,000 = 175,000
3. Adjust for changes in working capital:
- Prepaid expenses decrease: 175,000 + 5,000 = 180,000
- Accrued expenses decrease: 180,000 - 15,000 = 165,000
Net cash provided by operating activities: 165,000These examples demonstrate how adjustments are made to net income to reflect the actual cash generated or used in operating activities.
Preparing Cash Flow using the Indirect Method
Step 1: Net Income
Begin with the net income figure from your income statement. Net income represents the company's profit after accounting for all revenues and expenses during the period under accrual accounting, which may not reflect actual cash flow.
Net Income = 200,000Step 2: Add back Non-Cash Expenses
Adjust net income by adding back non-cash expenses that reduced profit but didn't involve cash outflows. These include depreciation and amortization, which allocate the cost of assets over time without requiring cash payments in the current period. Common non-cash expenses include:
- Depreciation expenses
- Amortization expenses
- Provision for doubtful accounts
# Add Back Non-Cash Expenses
Depreciation expense = 25,000
Amortization expenses = 10,000
Adjusted net income = 200,000 + 25,000 + 10,000 = 235,000Step 3: Subtract Non-Operating Gains and Add Non-Operating Losses
Exclude gains or losses from investing and financing activities to focus solely on operating cash flow. For instance, gains from selling equipment increase net income but don't reflect cash from operations, so they should be subtracted.
# Subtrack Non-Operating Gains and Add Non-Operating Losses
Gain on Sale of Equipment: 5,000
Adjusted Net Income: 235,000 - 5,000 = 230,000Step 4: Adjust for Changes in Working Capital
Modify net income for changes in current assets and liabilities from the beginning to the end of the period. This adjustment reflects the cash impact of operational activities on working capital.
Changes in Current Assets (Excluding Cash and Cash Equivalents)
- Increase in Current Assets: Subtract from net income; cash was used to increase these assets.
- Decrease in Current Assets: Add to net income since it implies cash was freed up.
An increase in accounts receivable means more sales were made on credit, using cash without immediate inflow—thus, it's subtracted. A decrease in inventory suggests less cash spent on purchasing stock, so it's added back.
# Increase in current assets
Accounts receivable increase: 15,000
Adjusted net income: 230,000 - 15,000 = 215,000# Decrease in current assets
Inventory decrease: 8,000
Adjusted net income: 215,000 + 8,000 = 223,000Changes in Current Liabilities
- Increase in Current Liabilities: Add to net income; cash was conserved by delaying payments.
- Decrease in Current Liabilities: Subtract from net income as cash was used to pay off obligations.
An increase in accounts payable indicates the company hasn't yet paid its suppliers, retaining cash—so it's added. A decrease in accrued expenses means cash was used to settle liabilities, thus subtracted.
# Increase in current liabilities
Accounts payable increase: 12,000
Adjusted net income: 223,000 + 12,000 = 235,000# Decrease in current liabilities
Accrued expenses decrease: 4,000
Adjusted net income: 235,000 - 4,000 = 231,000Step 5: Calculate Net Cash Provided by Operating Activities
After all adjustments, the final figure represents the net cash generated or used by operating activities. This number reflects the company's ability to generate cash from its core business operations.
# Net cash from operating activities
Net cash from operating activities = 231,000Summary of Adjustments
Key Points to Remember
- Non-Cash Expenses: Always add back expenses that didn't require cash payments, such as depreciation and amortization, to adjust net income to actual cash flow.
- Non-Operating Items: Remove gains and losses unrelated to operating activities to focus on cash generated from core business operations.
- Working Capital Adjustments: Recognize that increases in current assets consume cash, while increases in current liabilities provide cash.
Difference Between the Direct and Indirect Method
The direct and indirect methods are two approaches to presenting the cash flows from operating activities in a cash flow statement. While both methods arrive at the same net cash flow figure, they differ in presentation and the process used to calculate cash flows.
Direct Method
The direct method lists all major operating cash receipts and payments during the period. It provides a clear view of where cash is coming from and how it's being used in operations.
# Cash inflows
Cash received from customers: 500,000
# Cash outflows
Cash paid to suppliers: (300,000)
Cash paid for operating expenses: (100,000)
Cash paid for interest: (20,000)
Cash paid for taxes: (30,000)
# Net cash provided by operating activities
500,000 - 300,000 - 100,000 - 20,000 - 30,000 = 50,000Indirect Method
The indirect method starts with net income and adjusts for non-cash expenses, non-operating gains or losses, and changes in working capital accounts.
Net income: 70,000
# Add back non-cash expenses
Depreciation expense: 30,000
# Adjusted for changes in working capital
Increase in accounts receivable: (10,000)
Decrease in inventory: 5,000
Decrease in accounts payable: (15,000)
# Total adjustments
30,000 - 10,000 + 5,000 - 15,000 = 10,000
# Net cash from operating activities
70,000 + 10,000 = 80,000Key Differences
Summary of Direct vs. Indirect Method of Calculating Cash Flow
The direct and indirect methods are two approaches to presenting operating cash flows in a cash flow statement. The direct method lists actual cash receipts and payments, providing a clear view of cash inflows and outflows from operations. The indirect method starts with net income and adjusts for non-cash expenses and changes in working capital to calculate operating cash flow. While the direct method offers detailed cash transaction insights but requires extensive data collection, the indirect method is easier to prepare using existing financial statements and highlights how accrual accounting affects cash flow.
Indirect Method for Cash Flow Statements - FAQ
Q: Why do companies prefer the indirect method?
A: Companies often prefer the indirect method because it is less time-consuming and easier to prepare. The indirect method utilizes information already available from the income statement and balance sheet without the need to track individual cash transactions.
Q: How does depreciation affect the cash flow statement in the indirect method?
A: Depreciation is a non-cash expense that reduces net income. With the indirect method, depreciation is added back to net income because it does not involve actual outflow of cash.
Q: Is the indirect method acceptable under both GAAP and IFRS?
A: Yes, both the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) accept the indirect method for preparing the cash flow statement. I.e., choosing between the indirect method and the direct method is simply up to personal preference.
Q: Does the indirect method affect investing or financing on the cash flow statement?
A: No, the indirect method only affects operating activities on the cash flow statement. Investing and financing operations are prepared the same way under both the direct and indirect method.