Cash Flow Statement Indirect Method Solved Examples and Analysis

The indirect method of preparing a cash flow statement can be a bit tricky, but don't worry, we're here to break it down step by step.

To start, the indirect method begins with net income from the income statement and adds back any non-cash items, such as depreciation and amortization. This is based on the example where XYZ Inc. starts with a net income of $100,000.

The indirect method then adds back any increases in working capital accounts, such as accounts receivable and inventory, to arrive at the net change in operating assets. This is illustrated in the example where XYZ Inc. adds back $20,000 for the increase in accounts receivable.

The net change in operating assets is then subtracted from the net income to get the net cash provided by operating activities. In the example, this results in a net cash provided by operating activities of $80,000.

A cash flow statement is a financial document that shows the inflows and outflows of cash and cash equivalents over a specific period of time, typically a month or a year. It's like a snapshot of your company's financial health.

The indirect method of preparing a cash flow statement involves adjusting net income to determine net cash provided by operating activities. This method is often used because it's easier to understand and calculate.

By using the indirect method, you can see how changes in accounts such as accounts receivable and inventory affect cash flow. For example, if accounts receivable increase, it means customers are taking longer to pay their bills, which can negatively impact cash flow.

The indirect method also involves adding back non-cash items such as depreciation and amortization to net income. This is because these items don't affect cash flow, but they do affect net income.

The indirect method of preparing a cash flow statement is a bit more complex than the direct method, but it's still a straightforward process. The first step is to start with the net income for the period.

The indirect method begins with the net income for the period, followed by non-cash expenses, gains, and losses that need to be added back to or subtracted from net income. These non-cash activities typically include depreciation expense, amortization expense, depletion expense, gains or losses from sale of assets, and losses from accounts receivable.

To prepare the indirect method, you need to think about how changes in asset accounts affect cash. If an asset account increases during the year, cash must have been used to purchase the new asset, so you subtract the increase from the net income. If an asset account decreases, you add the decrease back into the income.

Here's a general rule of thumb to keep in mind: asset account increases should be subtracted from income, and asset account decreases should be added back into income. For example, if inventory increases, you subtract the increase from the net income.

The next step is to adjust net income for changes in liability accounts affected by cash during the year. This includes accounts payable and accrued expenses. If a liability account increases, it means you purchased something without using cash, so you add the increase back into income. If a liability account decreases, you subtract the decrease from the income.

Here's a basic tip for liability accounts: liability account increases should be added back into income, and liability account decreases should be subtracted from income.

Here's a summary of the indirect method format:

By following these steps, you can easily prepare a cash flow statement using the indirect method.

Computing cash flow from operations is a crucial step in creating a cash flow statement. It involves reconciling the net income from the income statement to the actual cash generated by the business.

The indirect method is a simpler approach, where you start with the net income and adjust it for non-cash items, such as depreciation and amortization. This method is preferred by many small businesses.

To calculate cash flow from operations using the indirect method, you need to identify the non-cash items and reverse them. For example, depreciation and amortization are recorded as expenses on the income statement, but they don't affect cash flow.

Depreciation and amortization are added back to net income to get the cash flow from operations. This is because they don't represent actual cash outflows.

The changes in working capital, such as accounts receivable and inventory, also affect cash flow. An increase in accounts receivable is subtracted from net income because it represents a cash outflow. Conversely, an increase in accounts payable is added to net income because it represents a cash inflow.

Here's an example of how to calculate cash flow from operations using the indirect method:

This calculation shows that the cash flow from operations is $53,666, which is the result of reconciling the net income with the changes in working capital and non-cash items.

The direct method of computing cash flow is a straightforward approach that lists all the cash receipts and payments from operating activities. The direct method is intuitive and easy to understand, making it a popular choice among accountants.

To prepare the operating activities section using the direct method, you need to list all the cash receipts and payments from operating activities. This includes cash received from customers, cash paid to suppliers, cash paid to staff, and other operating payments.

Here's a breakdown of the cash flows from operating activities using the direct method:

The direct method is relatively straightforward, and all the data are cash flows, making it easy to list the receipts as positive and the payments as negative. This results in a clear and concise operating activities section of the cash flow statement.

The direct method also highlights the cash generated from operating activities, which is the net result of all the cash receipts and payments from operating activities. In the example provided, the cash generated from operations is $174,000.

The indirect method of computing cash flow is a more common approach used by companies to calculate cash flow from operating activities. It requires starting with net income from the income statement and making adjustments to "undo" the impact of accruals made during the reporting period.

Some common adjustments include depreciation and amortization. The indirect method is simpler and faster to prepare compared to the direct method, but both methods are accepted by Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

Here's an example of how the indirect method works: Net income is listed first, followed by adjustments for expenses, gains, losses, asset accounts, and liability accounts. This process is illustrated in Example 12.

Calculating the dividend paid is a crucial step in the indirect method of computing cash flow. This can be done by reconciling the opening to closing balance of retained earnings.

The starting point is to identify the opening balance of retained earnings, which in our example is $500. This is a credit balance, meaning it represents the company's accumulated profits over time.

To calculate the dividend paid, we need to consider the profit for the year, which is $450. This is a credit and increases the retained earnings.

Here's a step-by-step breakdown of the calculation:

The actual year-end retained earnings is $700, which means we need to subtract the dividend paid from the total balance.

The dividend paid is the balancing figure that explains why the actual year-end retained earnings is less than the total balance. In our example, the dividend paid is $250.

Depreciation and Amortization (D&A) are non-cash expenses that reduce net income in the income statement. They allocate the cost of an asset over its useful life, and are typically added back into the cash flow statement to adjust net income.

Depreciation involves tangible assets, such as buildings, machinery, and equipment, while amortization involves intangible assets, such as patents, copyrights, goodwill, and software. This means that while these expenses are recorded on the income statement, no actual cash transactions are involved.

The value of these assets declines over time, so D&A is a necessary adjustment to accurately reflect cash flow. In the indirect method of computing cash flow, D&A is added back to net income to reconcile it with cash generated by operating activities.

Here's a breakdown of the D&A adjustment:

The first step in preparing a cash flow statement using the indirect method is to determine the net income from the income statement. This value can be found on the income statement of the same accounting period.

Net income is the total income, after expenses, for the period. For example, in our cash flow statement example, the net income is $37,037.

To determine the net income, you'll need to start with the profit before tax, which is listed on the income statement. Then, you'll need to make adjustments to reconcile the profit to cash flow, such as adding back depreciation and amortization.

Here's a breakdown of the adjustments to reconcile net income to cash generated by operating activities:

Note that the amounts in the table are based on the example provided in the article, and may not reflect actual values.

By making these adjustments, you can reconcile the net income to the cash generated by operating activities, which is a crucial step in preparing a cash flow statement using the indirect method.

The cash flow statement is typically divided into three main sections: Cash Flow from Operating Activities, Cash Flow from Investing Activities, and Cash Flow from Financing Activities. These sections help businesses track the flow of cash in and out of the company.

Each section has its own unique line items, but the general setup is usually the same. For instance, Cash Flow from Operating Activities includes items like cash earned from selling products or services, while Cash Flow from Investing Activities includes items like purchasing equipment or investing in other companies.

Here's a breakdown of each section:

The three main sections of a cash flow statement are where the magic happens. Each section represents a different way cash can enter and leave your business.

Cash Flow from Operating Activities is the main way your business makes money, by selling products or services. This is the lifeblood of your business.

Cash Flow from Investing Activities is cash earned or spent from investments your company makes, such as purchasing equipment or investing in other companies. You might need to take out a loan or use cash on hand to make these investments.

Cash Flow from Financing Activities is cash earned or spent in the course of financing your company with loans, lines of credit, or owner’s equity. This can be a complex section, but essentially it's about how you're funding your business.

Here are the three main sections of a cash flow statement, summarized:

You can think of these sections like three different doors to your business. Each door represents a different way cash can flow in or out.

The cash flow statement is a crucial tool for understanding a company's liquidity and financial health. Most companies report using the indirect method to present cash from operating activities.

The indirect method begins with a measure of profit, which can be net income, operating profit/EBIT, or earnings before tax. Many companies use net income, but others may choose a different profit metric.

A key consideration when using the indirect method is the starting point for the reconciliation. If the starting point profit is above interest and tax in the income statement, then interest and tax cash flows will need to be deducted if they are to be treated as operating cash flows.

The exact adjustments made will depend on the starting point for the reconciliation, which can vary from company to company. This means that companies may have some discretion in presenting their cash from operating activities.

Here's a breakdown of the components involved in the indirect method:

The indirect method can be a bit more complex to understand, but it's essential to grasp the underlying principles to make informed decisions about a company's financial health.

The Investing section of a cash flow statement reveals how a company is using its cash to acquire and dispose of non-current assets and other investments. This can include the purchase or sale of property, plant, and equipment (PP&E).

Cash flow from investing activities can be a significant outflow, especially for companies with growing operations. In fact, a company may spend tens of thousands of dollars on new equipment or property.

The Investing section can be broken down into several key activities, including purchases of marketable securities, proceeds from maturities and sales of marketable securities, and payments made in connection with business acquisitions.

Here are some specific examples of investing activities:

Investing cash flows can have a significant impact on a company's overall cash position, so it's essential to carefully review this section when analyzing a company's financials.

The financing section of the cash flow statement is where you'll find cash inflows and outflows related to financing activities. This includes cash flows from both debt and equity financing.

Debt financing includes borrowing and repaying bank loans or bonds. For example, a company might issue long-term debt and receive $16,896 in cash, as seen in the example.

Equity financing includes issuing and buying back shares, as well as paying dividends. In one example, a company paid $10,564 in dividends.

Here are some examples of financing activities:

The net result of these financing activities can be a decrease in cash and cash equivalents, as seen in the example where cash used in financing activities was $16,379.

The cash flow statement is often misunderstood as being a simple duplication of the income statement. However, it's a crucial financial report that provides a detailed picture of a company's cash inflows and outflows.

You use information from your income statement and your balance sheet to create your cash flow statement. The income statement lets you know how money entered and left your business, while the balance sheet shows how those transactions affect different accounts—like accounts receivable, inventory, and accounts payable.

The cash flow statement makes adjustments to the information recorded on your income statement, so you see your net cash flow—the precise amount of cash you have on hand for that time period. This is especially important because accrual basis accounting can lead to a mismatch between income reported on the income statement and cash on hand.

Depreciation is a great example of this. It's recorded as a monthly expense on the income statement, but you've already paid cash for the asset you're depreciating. The cash flow statement takes that monthly expense and reverses it—so you see how much cash you have on hand in reality, not how much you've spent in theory.

Here's a quick rundown of the four rules for converting information from an income statement to a cash flow statement:

By following these rules and using information from your income statement and balance sheet, you can create a comprehensive cash flow statement that gives you a clear picture of your company's cash flow.