Cash flow statement indirect method: How and when to use

Cash flow is a crucial component of a company’s operations. Therefore, it is important to clearly and accurately present this information to internal and external members.

There are many advantages to preparing a cash flow statement using the indirect method. The main benefit is the simplicity of preparing it.

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What is the cash flow statement indirect method

The cash flow statement indirect method is one way to present a company’s total cash flow. In this method, you begin with the net income and adjust it to calculate the company’s operating cash flow. You can gather this information from the company’s balance sheet and income statement.

This method is generally easier to prepare, and most companies use this method.

Some professionals do not prefer this method because the source of cash flows can sometimes be unclear. However, around 90% of public companies use the indirect method because of its simplicity.¹

How to create a cash flow statement using indirect method

A cash flow statement using the indirect method differs from the direct method of preparing a cash flow statement.

The following steps listed below show you how to prepare a cash flow statement using the indirect method. If you are preparing a cash flow statement using the indirect method, you can follow these steps.

Collect required documentation

Before beginning, you will need to collect the necessary financial information. In this case, you will need information from the company’s income statement and balance sheet. This information should come from the same period, such as a certain year or quarter.

List your net income

The very first line of the indirect cash flow is always the company’s net income. You do not need to include other information from the company’s income statement.

List your Operating Expense and Income

After this, you will enter your operating income and expenses. Doing this allows you to adjust accounting figures in the net income statement that do not impact cash flow.

List income gained or lost via investing

You also need to list any investments, such as new purchases and the sale of certain assets. You may need to include information such as a company purchasing new equipment or other assets.

List income gained or lost via financing

After this, you need to add or subtract any items related to the company’s financing operations. For example, if a company pays off part of its debt, you should include this amount.

Tabulate the total

After you complete this step, you will list the net change in cash based on these changes in operating, financing, and investing cash flow. You can use this information to calculate the net change in cash and cash equivalents.

List the final cash balance

After this, you can add the change in cash to the cash at the beginning of the period to arrive at the final cash balance.

Cash flow statement indirect method example

Below is an example of an indirect method cash flow statement. This statement will include information about the company’s operating, investing, and financing activities.

Operating activities: In this example, we started out adjusting the net income to calculate the operating cash flow. We added depreciation and accounts receivable losses and then subtracted the gain on assets sales and the reduction in salaries payable.

Investing activities: After this, we adjusted the operating cash flow figure based on investing activities. Investing activities are cash flow activities used to generate profits for the company. The purchase of property, plant, and equipment was deducted, and we also added proceeds from an asset sale.

Financing Activities: Finally, common financing activities, such as issuing dividends or common stock, also impact this cash flow statement.

Final Cash Flow Amount: After making all these adjustments, we arrived at the final cash flow amount of $1,980,000. If you know the company’s beginning cash balance, you can add or subtract this amount to arrive at the ending cash balance.

Another important metric you can examine is the company’s free cash flow. The free cash flow is equal to the company’s operating cash flow minus its capital expenditures.

Accounts Receivable example: For example, a company may sell $30,000 of software in July 2023. However, they may not receive the cash until September 2023. Under the accrual method, the company recognizes revenue in July, even though the company does not receive cash until September.

Companies often receive cash at a later point in time. Because of this, you need to adjust the company’s net income to correctly calculate the operating cash flow.

Depreciation example: Furthermore, the income statement includes certain items, like deprecation, that do not impact cash flow. A company’s net income may appear very low because of a significant depreciation expense. However, this depreciation does not impact the company’s cash flow.

Cash flow statement direct vs indirect method

There are several key differences between the direct method and the indirect method.

• The Accounting Standards Codification 230 standards allow companies to use direct or indirect method cash flow statements.²
• The Generally Accepted Accounting Principles (GAAP) in the United States allow businesses to use the indirect method.³

The indirect method starts out with accrual accounting, as it begins with the company’s net income. Accrual accounting states that revenue and expenses should be recognized when earned or incurred. Most companies use the accrual method.

The direct method does not need any adjustments because it is based on cash transactions. It does not use accrual accounting.

How to identify direct and indirect method of cash flow statement?

The indirect method takes the company’s net income and adds or subtracts the difference between non-cash transactions. This step adjusts income statement items that are not cash transactions.

In contrast, the direct method only displays cash transactions and includes operating, financing, and investing cash flow. The main difference between these 2 statements is how they calculate operating cash flow.

The main way you can spot the difference between the direct method and indirect method is as follows:

• The indirect method always starts with the net income and makes adjustments.
• In contrast, the direct method only includes cash transactions.
• The operating cash flow calculations are different for both of these methods.

Conclusion: When should you prepare a cash flow statement using the indirect method?

The indirect method is a convenient method used to present a company’s cash flow. Accounting boards and other institutions may prefer the direct method. However, most companies use the indirect method because of its simplicity.

This method can be helpful if you don’t know the total cash inflow or outflow. In this case, you can begin with the net income and make adjustments until you find the change in cash.

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All sources checked July 28, 2023.