The Indirect Method of Cash Flow Statement

Let’s get straight to the point: the indirect method is how most businesses prepare their cash flow statement. It’s practical, straightforward, and links the cash flow to the income statement. But why? Well, it’s simpler and way easier to handle than the direct method, especially when things get complicated. Instead of tracking every single cash inflow and outflow, this method starts with net income and works backward, adjusting for things that don’t involve actual cash. You get a clearer picture of how cash moves through a business without getting bogged down in the weeds.

What is the Indirect Method?

The indirect method starts with net income, which is the profit or loss a company reports after all expenses, revenues, and taxes are accounted for. But here’s the catch: net income doesn’t give you the full cash picture. That’s because it includes non-cash items like depreciation, amortization, and even things like changes in working capital. So, the indirect method adjusts for these factors to show what actual cash came in and went out.

How Does the Indirect Method Work?

Before getting into the details of how the indirect method actually works, you need to know what it is that this method does: it focuses on the net income figure and works its way backwards, making adjustments for non-cash and for working capital. Here’s how the process unfolds:

1. Start with Net Income

Net income is the first step. You pull it directly from the income statement. This number tells you whether the company made money or lost money during the period. But that’s just part of the story. Net income includes non-cash items like depreciation and things that don’t actually impact cash, like credit sales. So, we need to break it down further.

2. Adjust for Non-Cash Items

Here’s where the real work begins. The most common non-cash items you’ll deal with are:

Depreciation: This is a charge to reflect the gradual wear and tear of assets, but it doesn’t involve any cash going out the door. Depreciation is then added back to net income.

Amortization: Like depreciation, but for intangible assets. Same deal: add it back.

Gains/Losses on Sales: If you sold something like equipment, any gain or loss gets included in the net income, but it doesn’t affect cash. So, you adjust for that too.

The point is, these items mess with the net income number, but they don’t involve actual cash movements. You need to eliminate their effect to see the real cash flow.

3. Account for Changes in Working Capital

Now we go to working capital, which is simply current assets minus current liabilities, easy as that, and shows how much working capital a company has. Of course, such changes can greatly influence cash flow within an organization. For example

If accounts receivable (money customers owe) goes up, it means you’ve made sales on credit, but cash hasn’t come in yet. So, subtract that increase.

If accounts payable (money you owe suppliers) increases, it means you’re holding on to cash longer and not paying your bills immediately. So, add that increase.

Essentially, if working capital goes up, cash is tied up. If it goes down, cash is freed up.

4. Cash Flow from Operating Activities

After adjusting for non-cash items and working capital changes, you get cash flow from operating activities. This number shows how much cash the company generated from its core business operations. This is what investors really care about: is the business making money in a way that actually brings in cash, or is it just paper profit?

This step is critical because it gives you the actual picture of how the business is performing in cash terms, as opposed to just showing whether it’s profitable on paper.

5. Investing and Financing Activities

Once you’ve dealt with operating activities, you’ll need to include cash flows from investing and financing activities. These sections are separate from operating activities, and they deal with things like:

Investing: Cash used to buy or sell assets like property, plant, or equipment.

Financing: Cash that comes from issuing debt, issuing stock, or repaying loans.

These are essential to get the full picture, but the indirect method doesn’t deal with them in the same way. They show up separately in the cash flow statement.

Why Do Businesses Use the Indirect Method?

The indirect method is used by many businesses, mostly larger ones, for plenty of reasons:

Simplicity in preparation: Adjusting net income for alteration in working capital is comparatively easier than tracking every single transaction, as it is needed in the direct method.

Linking with the income statement: Since the indirect method begins with net income, a link directly bridges the income statement and the statement of cash flow. This is how you get to grasp how profitability gives a physical meaning in actual cash terms.

Reflects true cash position: The adjustments for working capital and non-cash items provide a clearer picture of a company’s cash flow from operations, which is often more important than net income alone.

Why Is It So Popular?

Efficiency: It’s much easier to adjust for changes in working capital and non-cash items than to try and track every single transaction.

Connections with Financial Statements: It ties the income statement and cash flow statement together. You get a clearer view of how net income turns into cash.

Practicality: It’s the go-to method for most companies because it’s simple to calculate and doesn’t require detailed records of every single cash inflow and outflow.

The Drawbacks

It’s not perfect. The biggest issue? It doesn’t give you as detailed a breakdown of cash receipts and payments as the direct method would. With the indirect method, you’re left with more general figures. You can’t see exactly where cash came from or went. But for most businesses, it’s a trade-off that’s worth making for the sake of simplicity.

Another downside? The changes in working capital can get tricky to calculate, especially for companies with fluctuating inventories or receivables.

Questions to Understand your ability

Que.1 What’s the very first thing you do when using the indirect method for cash flow?

A) Tally up non-cash stuff

B) Start with the net income figure

C) Mess with working capital changes

D) Figure out investing cash flows

Que.2 Which of these gets added back to net income in the indirect method?

A) When customers owe you more money (Accounts Receivable increase)

B) Depreciation (because it doesn’t drain cash)

C) Cash from selling equipment

D) Money you owe suppliers (Accounts Payable increase)

Que.3 In the indirect method, why do we adjust for changes in working capital?

A) To figure out where cash really went

B) To account for how much cash you’ve spent on new assets

C) To see how the company’s assets and liabilities are moving around

D) To make sure cash from financing is correct

Que.4 Why is the indirect method the go-to for most businesses?

A) It tracks every little cash inflow and outflow

B) It’s a shortcut that ties net income to cash flows without too much hassle

C) It’s easier to handle without dealing with non-cash items

D) It’s the only method that can handle complex transactions

Que.5 What’s the biggest downside of using the indirect method?

A) Tracking of every transaction

B) Too much of details causing more confusion

C) You are unable to demonstrate the precise source or destination of the funds.

D) It’s hard to link net income with cash flow

Conclusion

In short, the indirect method of preparing a cash flow statement is straightforward and practical. It takes the net income, adjusts for non-cash items and working capital changes, and then shows you the real cash flow. It’s the most commonly used method because it’s efficient and links back to the income statement. While it’s not as detailed as the direct method, it’s still the most reliable and widely used tool for understanding a company’s cash movements. Simple, effective, and to the point—this is why the indirect method is a staple in accounting.