Good cash flow management is the lifeblood of a company’s financial health. It ensures that operations are conducted without interruptions and that the business is able to grow sustainably. In reality, 82% of businesses are closed simply because of poor cash flow management.
If you want to make your financial reporting less complicated and gain a better understanding of cash flow in your business, the cash flow statement indirect method is the answer. This method connects net income with actual cash flow and demonstrates how earnings are converted into cash. Additionally, it allows you to see the impact of non-cash transactions and changes in working capital on your net profit.
What is a cash flow statement?
Combined with the income statement and balance sheet, the cash flow statement is one of the three fundamental financial statements used by businesses. It helps you identify where money is coming in and going out by tracking how it moves through your business’s financing, investment, and operating activities.
The cash flow statement only looks at cash movement, as opposed to the income statement, which calculates profit. This makes it one of the most straightforward methods to assess short-term liquidity.
What is the cash flow statement indirect method?
One way to display a company’s overall cash flow is to use the cash flow statement indirect method. This approach calculates the company’s operating cash flow by starting with the net income and making adjustments. The company’s income statement and balance sheet can provide you with this information.
The majority of businesses use this approach because it is typically easier to prepare.
Because it can occasionally be difficult to determine the source of cash flows, some specialists do not favor this approach. However, due to its ease of use, the indirect technique is employed by almost 90% of publicly traded corporations.
Reasons Companies Choose the Indirect Method
Most companies prefer the indirect way as it is efficient, generally accepted, and can be prepared easily from the existing records.
- Supports accrual accounting: Connects net income and cash flow to deliver a comprehensive picture of the financial situation.
- Minimizes transaction tracking: Relies on information extracted from previously prepared financial statements.
- Ease preparation: It eliminates the necessity of recording each cash transaction separately.
- Demonstrates cash generation efficiency: Shows how well net income is transformed into cash that is available for use.
- Meets international accounting standards: Complies with both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
Steps to Prepare a Cash Flow Statement Using the Indirect Method
With the indirect method, net income is first adjusted for non-cash items and changes in working capital to arrive at cash generated from operations.
1. Begin with net income
Start with the net income number from your income statement. This figure can be found on the last line and represents the profit after all revenues and expenses have been taken into account for the period.
2. Account for non-cash expenses
Adjust for non-cash expenses:
Depreciation and amortization: Add back (already reduced net income, but no cash was spent).
Other non-cash items: Add charges for impairments, stock compensation expenses, deferred tax charges, or provisions for bad debts.
Adding them back brings net income in line with the actual cash flow.
3. Incorporate changes in working capital
Make adjustments for changes in current assets and liabilities in order to reconcile net income with the actual cash effects.
| Account | Increase (Action) | Decrease (Action) | Explanation |
| Accounts receivable (AR) | Subtract | Add | AR rise means sales on credit tie up cash; decrease signals collections boosting inflows. |
| Inventory | Subtract | Add | Buildup consumes cash for stock; reductions free cash via sales. |
| Accounts payable (AP) | Add | Subtract | Higher AP delays payments (cash preserved); drops mean outflows settled. |
4. Compute cash flow from operating activities
These adjustments to net income show cash generated by operations.
Example:
- Net income: $200,000
- Depreciation (non-cash expense): +$30,000
- Increase in accounts receivable: –$20,000
- Decrease in inventory: +$10,000
- Increase in accounts payable: +$15,000
Calculation:
Cash Flow from Operating Activities = 200,000 + 30,000 – 20,000 + 10,000 + 15,000 = 235,000.
Your company has made $235,000 in net cash from operating activities.
5. Add Cash Flows from Investing and Financing Activities
Next, take into consideration the other activities along with operating cash flow to reflect the total cash movement.
Investing Activities: Analyze the cash outflow or inflow related to long-term assets like machinery or securities.
For example, purchasing new equipment costs $60,000 and selling a vehicle brings in $8,000, so the cash flow from investing activities is –$52,000.
Financing Activities: Illustrate the way in which your company generates or returns capital, for example, the cash inflows from issuing shares or taking loans, and the cash outflows from repaying debt, paying dividends, or repurchasing shares.
As an illustration, $50,000 from new stock issued minus $25,000 in loan repayments equals $25,000 in financing cash flow.
6. Complete the Cash Flow Statement
Add together all three sections to calculate the total cash change:
Net Change in Cash = Operating + Investing + Financing
= 235,000 – 52,000 + 25,000 = 208,000
Ending Cash:
If the beginning cash was $40,000:
Ending Cash = 40,000 + 208,000 = 248,000.
Here’s an example summary:
| Section | Cash inflows/outflows | Total |
| Operating activities | $235,000 | |
| Investing activities | –$52,000 | |
| Financing activities | $25,000 | |
| Net change in cash | 208,000 | |
| Beginning cash balance | 40,000 | |
| Ending cash balance | 248,000 |
7. Review and verify the statement
After comparing the totals with your financial statements, it becomes clear that the three types of cash flow, operating, investing, and financing, show the strength of activities, the extent of reinvestment, and the company’s funding strategy. Furthermore, regular cash flow reviews are very useful for spotting trends and planning investments.
Challenges of Using the Indirect Method
Even seasoned teams can slip up when preparing a cash flow statement using the indirect method. It is wise to watch out for these mistakes:
- Misclassifying transactions: Investing or financing transactions placed in the operating section can lead to misrepresentation of cash flows from operations.
- Omitting essential adjustments: Leaving out the non-cash activities, such as depreciation, or ignoring the working capital adjustments in accounts receivable (AR), inventory, or accounts payable (AP), misrepresents cash receipts and payments.
- Double-counting items: Repeating the recording of the same non-cash item (e.g., amortization) over and over will result in inflating operating cash flow; you should always check with previous reconciliations.
- Reversing inflow and outflow signs: Treating AP decreases as subtractions or AR and inventory increases as additions totally misstates cash flow; AP increases should be added, and AR and inventory increases subtracted.
- Not checking totals for accuracy: Even if the changes appear correct, errors can be missed unless the final cash corresponds to the balance sheet and the net change equals operating plus investing plus financing.
FAQs: Indirect Method Cash Flow Statement
Below are some frequently asked questions about the indirect method cash flow statement:
Why is the indirect method widely adopted in corporate reporting?
It is applied to 90-98% of public companies because it uses existing data from the income statement and balance sheet, making the process easier without requiring detailed tracking of cash transactions, as is required by the direct method (both comply with GAAP/IFRS).
How does the indirect method support financial decision-making?
Using the net income against operating cash flow, it shows the actual liquidity of the core business, assists in evaluating positive cash flow for investments, highlights risks from negative cash flow, and guides funding plans.
How frequently should companies prepare cash flow statements using the indirect method?
Public companies are required to prepare them quarterly, as per SEC/GAAP requirements. Startups should do the same monthly to monitor their runway, or even weekly if they are low on cash or in the middle of fundraising.
How does the indirect method improve transparency for investors?
It is a clear representation of adjustments such as the reinstatement of depreciation and accounts receivable, which allow investors to better understand how profits are translated into cash, making it easier to examine the quality of the cash a company generates against reported earnings.
How can the indirect method signal potential financial risks?
Negative operating cash flow and profits signal specific problems, such as growing AR (slow collections) or inventory accumulation, which may create liquidity limitations or unsustainable growth.
What are the limitations of the indirect method of cash flow?
The indirect method doesn’t lay out each individual cash inflow or outflow; thus, it depends on adjustments made to net income and can be harder to understand. Errors may occur due to complicated reconciliations and the likelihood of misclassifications, and it provides only limited details on the exact source or use of cash.
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