INDIRECT METHOD CASH FLOW: Formula & Examples

indirect method cash flow
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When preparing your cash flow report, one of the first decisions you’ll have to make is the method of computation you’ll use to calculate your net cash flow. The indirect method of cash flow is just your business’s cash income less your cash expenses over the same period, which can yield a positive or negative outcome and provide some insight into your company’s financial health. The direct and indirect method approaches are the two most prevalent methodologies for determining cash flow from operating operations. The indirect method cash flow statement example and formula will be detailed in this article.

The cash flow statement focuses on a company’s cash sources and uses. Investors, creditors, and other stakeholders examine it closely. It displays the implications of changes in asset and liability accounts on a company’s cash position and provides information on cash earned from various operations.

What is the Indirect Method of Cash Flow?

The indirect method is a financial reporting approach in which the statement of cash flows starts with net income and then adjusts for cash operational activities before arriving at an ending cash balance.

But if you work in a company’s accounting or finance department, you might need to understand how to create an indirect method statement of cash flows. The indirect method of cash flow provides information about cash flow that identifies the amount of money a company spent or made during a given time period and its source.

Indirect Method Cash Flow Statement Example

Under the accrual method of accounting, revenue is recognized when earned, not necessarily when cash is received. When a consumer purchases a $1,000 widget on credit, the sale is complete but the money has not yet arrived. The revenue is recorded in the month in which the sale was made. The indirect method of the cash flow statement tries to convert the record to the cash method in order to show actual cash inflows and outflows over time.

In this case, a $1,000 debit to accounts receivable and a $1,000 credit to sales revenue would have been made at the time of sale. The debit raises the number of accounts receivable, which is then shown on the balance sheet.

Even though no money was received in this instance, a $1,000 income was nonetheless recorded. As a result, net income was overstated by this sum on a cash basis. Furthermore, on the balance sheet, the offset was in the accounts receivable line item. On the cash flow statement, a reduction from net income in the amount of the $1000 increase in accounts receivable attributable to this sale would be required. In other words, an “Increase in Accounts Receivable (1000)” would be displayed.

Example

CASH FLOWS FROM OPERATING ACTIVITIES FOR THE YEAR ENDED DECEMBER 31, 2018,

Profit before tax.                                                  11,934
Adjustment for
Gain on disposal of property, plants, and equipment.                                        – 2750
Depreciation                                                      6000
Finance cost                                                         500
                                                      15,684
Changes in working capital items
Decrease/(increase) in inventory                                – 3250
Decrease/(increase) in trade receivables                                              3000
increase (decrease) in trade payables                                                1000
Increase /( decrease) in other payables                                                          250
Cash generated from operations                                                     10,184
Income tax paid (2000+3,750-250)                                  – 3,250
cashflow example

                                         Fixed Assets (PPE-Net book value)

Balance b/f                                     30,000Disposal                                                 7250
Revaluation                                       2,500Depreciation                                        6000
Purchase of PPE                            20,375Balance c/f                                         39,625
                                                            52,875                                                                52,875
Fixed assets

In addition, remember that an income statement has restrictions, so you’ll need to account for earnings before taxes and interest. To calculate the cash flow for the company’s operating expenses, you must also account for non-operating expenses such as accounts payable, accounts receivable, inventory, depreciation, and accrued charges. 

Direct vs Indirect Method Cash Flow

The two approaches for creating a company’s cash flow statement are the direct and indirect cash flow procedures. The cash flows from the operating activities section of each method differ significantly, with changes in cash receipts and payments being reported there in the case of the direct cash flow method, while adjustments to assets and liabilities accounts are made to the net income in the case of the indirect cash flow method.

The three subcategories of the cash flow statement are operating, investing, and financing. While both direct and indirect methods can be used to calculate the investment and finance components.

  • Operating Activities: This activity, comprises revenue from sales of goods or services, purchases of supplies or materials, operating costs, and staff wages.
  • Investing Activities: This activity, comprises the purchase or sale of assets, and the payment or collection of loans.
  • Financing Activities: furthermore, this activity just includes stocks, bonds, or dividends.

Additionally, business owners, investors, creditors, and stakeholders review cash flow accounts to assess a company’s performance. A company may create monthly, quarterly, or annual cash flow statements.

Differences Between the Direct and Indirect Method of Cash Flow.

                    Direct                      Indirect
The cash received from consumers and the cash paid to suppliers, employees, and others are included in the direct method of cash flows in operating activities.The basis for the indirect method of cash flow is net income. It performs the necessary adjustments, such as adding and subtracting variables, to convert total net income to cash from operations.
The direct method of cash flow begins with cash transactions such as cash received and cash paid, whereas non-monetary transactions are ignored.In the indirect method of cash flow, all aspects are considered.
It takes a longer amount of time.In the indirect method, it takes less time compared to the direct method.
Only a few companies adopt this strategy in comparison to the indirect method.The indirect method is predominantly used by many companies.

Indirect Method Cash Flow Formula

You can estimate the cash flow using the indirect method formula approach by changing net income and by adding or removing differences from non-cash transactions. Non-cash items appear on the balance sheet as changes in assets and liabilities from one period to the next. Additionally, the value of net income (also known as net profit) at the end of the reporting period is calculated in order to determine it by utilizing the indirect method of the cash flow formula approach.

The first stage is to exclude non-cash transactions from net income. While depreciation expenditures are included in the investment cash flow category for fixed assets purchased during the reporting period, they are not relevant to cash flow.

The following step is to add or deduct changes in the cash value of specified operating activity categories. The final step is to apply the effect of the changes due to investment and financing cash flows after you’ve calculated the net effect of these operational cash flows using the indirect technique.

For example:

How to Work Out Your Cash Flow. Subtract your capital expenditure and change in working capital from your net income and depreciation. Net income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure = Free Cash Flow. 

Net Income
+Non-Cash Expenses:
(Depreciation, Depletion, & Amortization Expense)
+Non-Operating Losses:
(Loss on Sale of Non-Current Assets)
Non-Operating Gains:
(Gain on Sale of Non-Current Assets)
+A Decrease in Current Assets:
(Accounts Receivable, Prepaid Expenses, Inventory, etc.)
Increase in Current Assets
+Increase in Current Liabilities:
(Accounts Payable, Accrued Liabilities, Income Tax Payable, etc.).
Decrease in Current Liabilities
=Net Cash Flow from Operating Activities

Why Do We Use the Indirect Method of Cash Flow?

  • The indirect cash flow method is easier to use. The reason is that it doesn’t require as much information as that direct
  • The income statement and the balance sheet provide all the numbers required for the cash flow when using the indirect cash flow method.
  • The indirect method makes sure to convert the net income in terms of cash flow automatically.
  • Since it employs data that is already available and makes cash flow forecasting simpler, the indirect method is more frequently in use.

Furthermore, in order to prepare a cash flow statement using the indirect method, there are some keywords we ought to look out for.

#1. Setting up the Statement

When utilizing the indirect technique to calculate cash flow, you’ll first record net income for a given period before subtracting or adding non-cash items like expenses, losses, and profits. Depreciation, amortization, and depletion are examples of non-cash expenses.

#2. Adjust Your Net Income

Then you’ll have to alter your net income to account for any changes in asset accounts that may have had an impact on your company’s cash flow. Inventory, prepaid expenses, and accounts receivable are examples of these accounts. To figure out which direction your net income should be modified, you’ll need to compute how these adjustments influence cash. If an asset increases throughout the recording period, for example, cash leaves your organization, the increase must be deducted from net income.

#3. Account for Liabilities

Last but not least, make adjustments to your net income to account for changes in your liability accounts. Accounts payable and accumulated expenses are two of the accounts you’ll need to think about.

Conclusion

The indirect method of cash flow is considered in all aspects. Net income does not represent net cash flow from operating activities because the income statement is prepared on an accrual basis, in which revenue is recognized when earned rather than when received, however, it is necessary to adjust earnings before interest and tax for those items that affect net income even though no actual cash is paid or received against them.

Indirect Method Cashflow FAQs

What is the difference between direct and indirect method of cashflow

Only a few companies adopt this strategy in comparison to the indirect method while the indirect method is predominantly used by many companies.

What is the Indirect Method Cash Flow Formula?

It is calculated by adjusting net income by adding or subtracting differences resulting from non-cash transactions.

What is the Indirect Method of Cash Flow?

The indirect method of cash flow is a way to have data in a cash flow that demonstrates how much money a company made or spent during a specific time period and where the money came from.

  1. Cash Flow Statement Indirect Method: Overview, Examples, Calculations.
  2. Cash Flow Forecasting: Meaning, Methods, Tools, Models (plus Detailed Templates).
  3. Cash Flow Statement Direct Method: Overview, Examples, Pros & Cons.
  4. STATEMENT OF CASH FLOWS: Understanding the Statement of Cashflows with Examples.
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