Cash Flows Indirect Method | Complete Guide

Welcome to the topic “Cash Flows Indirect Method.”

The statement of cash flow’s indirect method adjusts net income due to the various changes and adjustments made in the balance sheet accounts to determine the cash (received or paid) from operating activities. In simple words, changes and adjustments made in a firm’s assets and liabilities that impact cash balances during the specific year are added back to or deducted from net revenue at the end of the fiscal period to conclude the operating cash flow.

Understanding the Cash Flow’s Indirect Method

The cash flow statement emphasizes the sources and uses of cash and its equivalents by a firm. The part is extremely significant for the investors, stakeholders, and creditors; hence it is under regular monitoring. The statement represents vital information regarding the cash generated from various activities and illustrates the positive and negative effects of changes in assets and liabilities accounts.

The indirect method of cash flow begins with net income or loss, followed by subsequent additions or deductions from the net income against non-cash expenses and revenues. Let’s take a closer look at the format of the cash flow indirect method:

Indirect Cash Flow Format

As mentioned above, the indirect cash flow starts from the net income for that period then followed by various non-cash expenditures, gains, and losses that are added back or subtracted from net revenue. Some of the non-cash activities that you will find in the statement include:

• Depreciation expense
• Amortization expense
• Depletion expense
• Recording of gains or losses from the sale of assets
• Losses from accounts receivable

The next section of the statement includes adjusted net income. This shows the changes in different asset accounts that impact the flow of cash of a business. Some of the common assets accounts are:

• Accounts receivable
• Inventory Balances
• Prepaid expenses
• Receivables from different vendors, employees, and owners.

At this point, cash flow’s indirect can get a little complicated, but overall it is simpler than the direct method. You will have to account for how changes in both assets and liabilities accounts affect the flow of cash to determine how you can adjust the income or what is the most appropriate way to adjust the revenue.

For example, if a business’s assets increase during a year, cash is also spent on purchasing new assets for the business. Thus, an increase in the asset account actually reduced cash, so you will have to adjust this increase from the business’s net income. Similarly, if any asset account decreases, you will have to add back that particular amount into the business’s net income. To make things simpler, always follow this simple rule while preparing an indirect cash flow statement:

When asset account increases, minus the amount from profit or net income.

When asset account decreases, add the amount to profit or net income.

The other section of the statement adjusts net income due to the changes and adjustments in liability accounts that affect the cash during the year. Some common accounts used for this purpose are:

• Accounts payable
• Accrued expenses

If you understand how to deal with the adjustment of assets in indirect, direct cash flow, this liability section will be pretty much straightforward for you. The only difference between the assets and liabilities section is that liabilities have a credit balance, not a debit balance like assets; hence the process becomes the opposite. When liability increases, you will have to add it back into the business’s net income. For example, If a common liability account “Accounts payable” increases, normally it means that the business has purchased equipment or something but not with cash. Thus, you will have to add back this amount. Follow this simple rule while dealing with the liability accounts:  

When liability increases, add back the amount from income.

When liability decreases, less the amount from income.

Lastly, all adjustments are totaled and later adjusted with the net income to match the cash account or balance.

Example of the Indirect Method

Here we have to follow the accrual method in which income is recognized when earned, not when we receive cash. For example, if a person (customer) purchases a $300 widget on credit. In this case, the sale is made but on credit, so no cash is received. However, the revenue will be recognized in the month of the sale.

The indirect cash flow statement reverts the record to the cash method to describe the inflow and outflow of cash during the period. In this particular example, when the sale was made, it means account receivable would have been debited, and a credit to sales revenue account shows $300. The debit increases the account receivable account, and it is shown on the balance sheet.

The indirect method of cash flow, net income, is shown on the first line. Then it is followed by changes or addition or reduction in assets and liability accounts. Then, you will need to adjust those changes from net income to determine the cash impact of that particular item.

In the example mentioned above, we didn’t receive cash, but the business earned a revenue of $300, and it will be recognized. Therefore, net revenue will be overstated by the amount on a cash basis. On the other hand, the counterbalance was made in the accounts receivable account. But there will be a reduction of $300 due to this sale in the cash flow statement. It will be shown as “Increase in Accounts Receivable ($300).”

Cash flow: Direct VS Indirect Method? Why Use Indirect Method?

The indirect cash flow method is simple, straightforward than the direct method as it doesn’t include minor details of cash movement.

Furthermore, businesses and firms typically reconcile their balance sheets line-by-line and reconcile every cash movement in the direct method. Hence, in the direct cash flow method, you will have to perform all the calculations of the indirect method as well.

On the other hand, the indirect cash flow method’s main advantage is that it gives more precise information assuming all the transactions for the cash received or paid.

The direct method becomes more effective when a firm or business is in distress and monitors and calculates the flow of cash thoroughly and regularly. However, in most situations, the indirect method of the cash flow is the practical choice.

Another major difference between both methods is operating activities. The cash flow’s direct method shows all cash receipts and payments from all sources to determine operating cash flows. This is a bit complicated and requires a separate reconciliation like indirect cash flow, and it is used to prove the operating activities are correct.

Most businesses and firms prefer the cash flow’s indirect presentation to the direct method because it is simple. The information required to prepare or generate is always available in accounting systems or records. To be precise, you can even prepare the indirect cash flow report without accounting systems and software as all the items are simple to obtain and prepare.

What is Cash Flow from Investing Activities?

Cash Flow from Investing Activities is a sub-division of a cash flow statement that shows how much amount you have used (or earned from) investments during the year. Many investing activities include purchases of long-term assets like plants and equipment, property, acquisitions of assets or other businesses, and making investments in stocks, bonds, and other marketable securities.

Investing Activities Examples in Cash Flow?

Let’s take a detailed look at the example of what is included in the investing activities. Under this segment of the cash flow statement, you will find many items; hence you should know how to treat them in accounting.

Investing activities in accounting include:

• Acquisition of land, property plant, and equipment (also known as capital expenditures).
• Proceedings from the sale of assets such as PP&E.
• Acquisitions of assets from other businesses or acquisitions of other companies.
• Proceedings from the sales of other firms or businesses.
• Purchases of stocks, bonds, and other marketable securities.
• Amount received from the sales of various marketable securities.

These were some common items that you will find in the investing activities section. However, there are many more that you will have to include in the cash flow statement. This is because every firm and business has different nature. The best approach to determine what should be included is to review the balance sheet and examine all the differences between fixed or non-current assets over the two periods or years. Any changes in the amount of these assets (other than the depreciation) mean an investing item you will have to show on the cash flow statement.

All the changes impacting a business’s cash position and involves assets, investments, or equipment will come under investing activities section.

Most companies want a positive cash flow. However, cash flow can also be negative due to several reasons. For example, if a firm or business make heavy investments in plant and equipment, this might result in the negative cash flow but leave a positive impact in the long run.

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