A statement of cash flows can be prepared by either using a direct method or an indirect method. In the indirect method, the net income is adjusted for changes in the balance sheet accounts to calculate the cash from operating activities.
Indirect Cash Flow Statement Template
Throughout this series on financial statements, you can download the Excel template below for free to see how Bob’s Donut Shoppe uses the statement of cash flows to evaluate the performance of his business.
Components of Indirect Cash Flow Statement
The main difference between the direct method and the indirect method involves the cash flows from operating activities. There is no difference at all in how the cash flow from investing activities or financing activities are calculated under both methods.
Operating Activities
Whether this calculated through the direct method or the indirect method, the total cash from operating activities will be the same and the only difference is in the format in which it is presented.
The operating section starts with the net income that has been calculated under accrual basis accounting and principles of matching and recognition. Therefore, this net income needs to be adjusted to remove the non-cash items.
Non-cash items such as depreciation & amortization expense, gains and losses from disposal of fixed assets, provisions for future losses, impairment expenses, deferred income taxes, etc. are added back to the net income. This is because, these non-cash items have previously impacted income statement which it would not have if the net income had been calculated on a cash basis from the beginning.
Next, the net income is also adjusted for changes in current asset, current liability and income tax accounts appearing on the balance sheet. An increase in the current asset accounts including accounts receivables, inventory, prepaid expenses, etc. will have a negative impact on cash flows and need to be subtracted from the net income. An increase in the current liability accounts including accounts payable, current portion of long-term debt, etc. will have a positive impact on cash flows and need to be added to the net income.
Rules for adjustments of balance sheet accounts
Current asset accounts
- Increase in accounts receivables will be subtracted from net income.
- Increase in Inventory will be subtracted from net income.
- Increase in prepaid expenses will be subtracted from net income.
- Decrease in accounts receivables will be added from net income.
- Decrease in Inventory will be added from net income.
- Decrease in prepaid expenses will be added from net income.
Current liability accounts
- Increase in accounts payable will be added to the net income.
- Increase in expense payables will be added to the net income.
- Increase in current portion of long-term debt will be added to the net income.
- Decrease in accounts payable will be subtracted from net income.
- Decrease in expense payables will be subtracted to the net income.
- Decrease in current portion of long-term debt will be subtracted to the net income.
All the above adjustments to the net income will give us the cash flow from operating activities for the period.
Investing Activities
As suggested by the name itself, these include acquisition and disposal of any non-current assets or any other investments. Understanding the nature of cash flows in this category is important for analysis of financial statements. While a negative cash flow from operating activities is an indication of poor performance by a company, a negative cash flow from investing activities could mean that the company has made fixed long-term investments that will eventually help its long-term health.
Typical examples will include:
- Purchase of fixed assets such as property, plant and equipment (PP&E) – a negative cash flow activity.
- Investment in long-term securities like stocks or bonds – a negative cash flow activity.
- Lending money to other individuals or institutions – a negative cash flow activity.
- Sale of fixed assets such as property, plant and equipment (PP&E) – a positive cash flow activity.
- Sale of investments – a positive cash flow activity.
- Proceeds from loans or insurance claim payouts – a positive cash flow activity.
If balance sheets of two period are compared side by side and there is a difference in the values of its non-current assets, then it means that there has been an investing activity with-in the period.
Financing Activities
These are activities that change the size of borrowings or equity for a company. Financing activities could include the following:
- Issuing new common stock – a positive cash flow activity.
- Issuing new debt offering – a positive cash flow activity.
- Stock repurchases – a negative cash flow activity.
- Dividend payments – a negative cash flow activity.
- Repaying borrowing or debt – a negative cash flow activity.
Advantages and Disadvantages of an Indirect Method
Both methods are useful and whether one method is given preference over the other will depend on the requirement of the company. The following are some of the advantages and disadvantages of preparing the cash flow statements using the indirect method:
- The indirect method is straight forward and has a simplified format.
- The indirect method helps in linking back to the income statement which presents the information in a systematic view. Many items on a company’s balance sheet can be traced back to the operating activities section of the cash flow statement.
- It helps in reconciling the net income with the cash position of a company.
- Disclosure of non-cash transactions helps users to better understand how they are part of the income statement but not the cash flow statement.
Indirect Method Statement of Cash Flows Example
We have already seen Bob’s Donut Shoppe cash flow statement prepared under the direct method. Let us see how the cash flow statement prepared through the indirect method would look like:
