Cash Flow Statement Indirect Method

Updated on April 13, 2024
Article byKumar Rahul
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is The Cash Flow Statement Indirect Method?

The cash flow statement indirect method, is a financial document that showcases the movement of cash in and out of a business over a specific period. Unlike the direct method, which directly records cash transactions, the indirect method begins with net income. It adjusts it for non-cash items and changes in working capital to derive the net cash provided or used by operating activities.

Cash Flow Statement Indirect Method

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The aim of the cash flow statement using the indirect method is multifold. It provides stakeholders with insights into a company’s liquidity position, revealing how effectively it manages its cash resources. Reconciling net income with cash flow from operating activities offers a clearer picture of a company’s cash-generating capabilities. It is independent of accrual accounting adjustments. 

Key Takeaways

  • The cash flow statement, using the indirect method, is a financial statement that shows how changes in balance sheet accounts and non-cash income statement items affect cash and cash equivalents.
  • The indirect method focuses on operating activities, revealing how much cash a company generates or uses in its core business operations.
  • One should adjust non-cash items (like depreciation) and changes in working capital to reflect the actual cash flow from operations.
  • The indirect method aligns with accrual accounting principles, providing a connection between the income statement and the cash flow statement.

How Does Cash Flow Statement Indirect Method Work?

The cash flow statement indirect method works by starting with a company’s net income from the income statement and then making adjustments to reconcile it to the actual cash generated from operating activities. Here’s a breakdown of the way it truly works:

  1. Start with Net Income: The process begins with the net income figure derived from the income statement, which represents the profit or loss of the company over a specific period.
  2. Adjust for Non-Cash Expenses and Revenues: Non-cash expenses such as depreciation and amortization are added because they help to calculate net income but do not involve the use of cash. Similarly, non-cash revenues are subtracted because they increase net income without actually generating cash.
  3. Account for Changes in Working Capital: One can adjust the changes in current assets and liabilities, such as accounts receivable, inventory, accounts payable, and accrued expenses, to reflect the cash flow impact. For example, an increase in accounts receivable would decrease cash flow, while an increase in accounts payable would increase cash flow.
  4. Calculate Cash Flow from Operating Activities: After making these adjustments, the resulting figure represents the net cash provided or used by operating activities.
  5. Include Cash Flows from Investing and Financing Activities: Finally, the addition of cash flows from investing and financing activities brings the net increase or decrease in cash and cash equivalents for the period.

Examples

Let us understand it better with the help of examples:

Example #1

The cash flow statement of a company named Alpha Corporation, using the indirect method, is given below, beginning with a net income of $800,000. The various adjustments are given in the Excel below.

In the above Excel sheet, the calculation starts with New Income.

Operating Activity – Value of depreciation, even though an expense, is non-cash in nature. Therefore, it will be added back to the cash flow statement since there is no actual cash outflow. Finally it is 800,000 + 100,000 = $900,000.

Next comes the working capital section. In this section, the items included are:

  • Accounts payable – This money is yet to go out of the business. It is still within the business, increasing the cash flow amount. Therefore, it should be added.
  • Accounts receivable – This is just the opposite of payables. Since the money is yet to be received and is not available for use within the business, it gets deducted.
  • Inventory – Treatment will be the same as receivables because the inventory should be sold to get cash.

The final figure, therefore, is (900,000 + 5,000 – 6,000 – 4,000) = $895,000.

Investment Activity – The items included in this section are:

  • Proceeds from matured marketable securities – These are funds acquired after selling off financial securities that the company purchased and that have matured in the current year. So it will be added.
  • Purchase of equipment – Purchase of equipment means the fund is leaving the business, resulting in a deduction from the cash flow statement.
  • Payment against business acquisition – Same as the above, the outflow of funds happens due to business acquisition. Therefore, the value is to be deducted.

The final figure will be (35,000 – 10,000 – 15,000) $10,000.

Financing Activity – The items appearing and their explanation are given below.

  • Dividend payment – Cash is leaving the business due to dividend payments on stocks to shareholders, resulting in a decrease in cash flow.
  • Loan repayment – Cash is moving out of the business due to debt repayment.
  • Proceeds from loan issued– The business may have extended loans for some purpose, which has been collected during the current period, resulting in cash inflow and an increase in cash balance.
  • Proceeds from commercial papers issued – Commercial papers, which are debt instruments meant to raise unsecured funds during the short term, have been issued to the public. So, funds have come into the business, increasing cash balance.

The final figure will be (-15,000 – 12,000 + 6,000 +22,000 ) $1000.

Now the addition of Operating, Investing, and Financing activity figures will result in a cash balance of $906,000 (895,000+10000+1000).

Example #2

Here is an example of the Cash Flow Statement of Apple Inc. (NASDAQ: AAPL), which shows the figures for the quarter ending December 2023.

Cash flow Statement Indirect Method - Example 2.jpg

The Excel sheet image above reflects the values for each section, the explanation of which is below:

In the Operating Cash Flow section, all four items, Depreciation and Amortization, Share-based compensation, and other Operating Activities, all bring in cash into the business. In the case of the Investing Cash Flow section, Capital Expenditure is a cash outflow and is deducted. The company did not make any acquisitions. However, the change in investment is positive, showing there is an increase in cash flow.

Other investing activities include cash outflow from the business, leading to a deduction. In the Financing Cash Flow section, all the items, Dividends paid, Share issuance/Repurchase, Debt Issued/Paid, and other Financing activities denote cash outflow from the business.

Now comes the calculation part.

  • For Operating Cash Flow, the final value is $39,895 (2,848 +2,997+134).
  • For Investing Cash Flow, the final value is $1,927(-2,392 +0+4,603-284).
  • For the Financing Cash Flow, the final value is $-30,585 (-3,825 – 20,139 – 3,984 – 2,637).
  • Thus, the value of Net Cash Flow is $11,237 (39,895 +1,927 -30,585).

In this case, the quarterly financials of Apple Inc. provide valuable insight into the method using which a cash flow statement of the business is calculated. It also points out some important items that commonly appear in the statements.

Having a clear understanding of the items will help an analyst, investor, or any other stakeholder get a proper idea about its cash position because it denotes the ability of the business to meet its short and long-term financial obligations without hampering its progress. It also points out the need to opt for external financing or items that are positively or negatively influencing the net income. In other words, the quality of earnings and various financial activities are identified along with the errors in reporting.

Forms

The cash flow statement using the indirect method typically follows a standard format consisting of three main sections: operating activities, investing activities, and financing activities.

  1. Operating Activities: This section begins with the company’s net income from the income statement. Adjust to reconcile net income to the actual cash generated or used by operating activities. Changes in working capital accounts, such as accounts receivable, inventory, accounts payable, and accrued expenses, are also considered to determine the net cash provided or used by operating activities.
  2. Investing Activities: This section includes cash flows related to the purchase and sale of long-term assets, such as property, plant, and equipment, as well as investments in securities. Cash outflows for capital expenditures and acquisitions are recorded, while cash inflows from asset sales or investment returns are included.
  3. Financing Activities: Here, cash flows from the company’s financing activities are presented. This includes cash inflows from borrowing (e.g., loans or issuing bonds) and cash outflows from debt repayments. Additionally, cash flows of equity transactions, such as issuing or repurchasing stock and paying dividends, are also included in this section.

Advantages And Disadvantages

The following are the benefits and drawbacks of the cash flow statement using the indirect method:

AdvantagesDisadvantages
Provides insight into cash managementCan be complex for non-financial users
Highlights operational efficiencyDependent on accurate accrual accounting
Helps assess liquidity positionMay require adjustments for comparability
Facilitates financial decision-makingDoes not provide granular detail
Helps identify trends in cash flowSubject to manipulation

Cash Flow Statement Indirect Method vs Cash Flow Statement Direct Method

Some of the differences between cash flow statements prepared by the indirect approach as opposed to the direct method:

AspectIndirect MethodDirect Method
ApproachStarts with net income and adjusts for non-cash itemsRecords actual cash receipts and payments
ComplexityMore complex, involving adjustments and reconciliationsSimpler, as it directly records cash transactions
Understanding by stakeholdersMay be challenging for non-financial usersEasier for non-financial users to comprehend
Accrual accountingDependent on accurate accrual accountingNot dependent on accrual accounting
Granularity of informationProvides a comprehensive view of cash flowProvides a more detailed breakdown of cash flows
Comparability with peersMay require adjustments for comparabilityFacilitates easier comparison between companies

Frequently Asked Questions (FAQs)

How does the cash flow statement indirect method contribute to financial analysis?

It provides valuable insights into a company’s cash management practices. Financial analysts use it to assess a company’s financial health. It evaluates its cash flow trends over time and compares its performance with industry peers.

Is the cash flow statement indirect method required for financial reporting?

Yes, companies prepare a Cash Flow Statement as part of their financial reporting. While both the indirect and direct methods are acceptable, the indirect method is common.

Can the cash flow statement indirect method be manipulated?

Like any financial statement, there is a potential for manipulation. However, the use of accrual accounting principles and reconciliation with other financial statements helps mitigate this risk. Auditors play a crucial role in ensuring the accuracy and integrity of the cash flow statement. 

This article has been a guide to what is Cash Flow Statement Indirect Method. We explain its format, examples, differences with direct method, & advantages. You may also find some useful articles here –

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