When using the indirect method what should be added to net income in determining net cash flow provided by operating activities?

The Cash Flow Statement Indirect Method is one of the two ways in which Accountants calculate the Cash Flow from Operations (another way being the Direct Method).

Being the simpler of the two, it is the method of choice for most Accountants and is therefore seen applied in the Cash Flow Statement for most Businesses.

This article examines the Indirect Method in detail and gives you step-by- step instructions on understanding the method and applying it.

The Article is divided into two Parts

PART 1 - An Overview of the Indirect Method with a focus on the framework.

PART 2- A deep dive into each element of the Indirect Method and why it is being applied the way it is.

You can always use our "QUICK NAVIGATION" Table of Contents below if you just want to hone in on a specific area.

To understand how to calculate the Cash Flow from Operations using the Indirect Method, you need to first be aware of all the inputs used to calculate it.

(Think of inputs as the Raw materials being used to create the Final Product).

The 5 major items (inputs) that you need to be aware of are -

2. Non Cash Expenses (Depreciation, Amortization)

4. Movement in Current Assets

5. Movement in Current Liabilities

The above information is pretty easy to obtain from the companies latest Income Statement and two simultaneous periods of the Balance Sheet.

Luckily, once you have these figures, the Calculation of The Indirect Method follows a set pattern, a consistent Format.

Know the Format, and the calculation of Cash Flows becomes really easy.

So, what's the format?

CASH FLOW FROM OPERATING ACTIVITIES: 

Net Income (taken from the Income Statement)

Add back (+):

Any Non Cash Expenses (Depreciation and Amortization)

Any Losses that the Business has incurred on the Sale of Non Current Assets.

Any decrease that has taken place in Current Assets (Accounts Receivables, Prepaid Expenses, Inventory etc. taken from the Balance Sheet)

Any increase in Current Liabilities (Accounts Payable, Accrued Liabilities, Income Tax Payable etc taken from the Balance Sheet).

Minus (-):

Any Gains that the Business has incurred on the Sale of Non Current Assets.

Any Increase in Current Assets (Accounts Receivables, Prepaid Expenses, Inventory etc. taken from the Balance Sheet)

Any decrease that has taken place in Current Liabilities (Accounts Payable, Accrued Liabilities, Income Tax Payable etc taken from the Balance Sheet).

Equals:

The Net Cash Flow from Operating Activities.

Even though the Format above includes all the aspects that can impact the Cash Flow from Operations using the Indirect Method - you will only apply what is relevant to the company you are analyzing.

To illustrate, the a Real Life Cash Flow From Operations would look like below -

To illustrate, the a Real Life Cash Flow From Operations would look like below -

Now, let's take a look at the break up of the major items individually and see why they get added (or subtracted) from Net Income.

We all know Profits are important.

But the Profits reported in the Income Statement are not always representative of the actual Cash that has come into the business when we use Accrual Accounting.

That's because Accrual Accounting includes

• Sales made on Credit 
• Supplies purchased on Credit 
• Depreciation and Amortization Expenses 
• Expenses accrued but not yet paid (Example, Salaries owed but not yet paid).  

While including the effect of the above transactions is great to give us an overall picture of health of the Business - it does have drawbacks.

The main drawback includes the fact that when each non cash transaction is added to the Income Statement - it builds a distance between the Net Income and Real Cash number of the Business.

So, naturally, we start with the Net Income with the goal of remove all the non cash elements that have been factored in its calculation (Kinda like peeling an Orange!)

Although a book entry, Depreciation and amortization expenses DO NOT not represent real uses of cash and are added back to Net Income.

For example, if a companies net income has been $500,000 on the Income Statement and depreciation expenses are $100,000, the depreciation expenses of $100,000 do not mean that actual cash of $100,000 has been used. It is simply a book entry and is therefore added back to find the net cash flow from operations - which would then total $600,000.

If your relatively new to Accounting and aren't sure how Depreciation works - you can check out an article on Depreciation here.

Technically, a Gain is an increase in the company value from something other than the Revenues and day to day running of the Business.

For example, a Gain can occur when a company property increases in value and the company sells it.

Despite the Sale increasing the Net Income figure, the Gain is not part of regular operations of the Business and therefore showing it as normal Cash Flow from Operations would be misleading.

Keeping that in mind, Gains are deduced from Net Income.

Similarly, Losses caused from Non Operating Activities (such as Lawsuits) reduce Net Income for the period.

Since non operating Losses are occasional occurrences (Hopefully at least!) we add them back to Net Income to show the true picture of Cash Flow from Operations.

Technical Stuff

RECORDING GAINS AND LOSSES

Asset purchases and sales are also considered investments, and the activity surrounding these actions is also considered investing activity.

Therefore, Asset sales have a dual impact on the Cash Flow Statement.

The Cash from the Sale of Assets is recorded in the Cash Flow from Investing Activities section of the cash flow statement as well as the Gain (or Loss) is recorded in the operating section.

Specifically, in the investing section you retire the asset by recording the total amount of sale proceeds you received for the assets whereas the Gains are deduced and Losses are added to the Cash Flow from Operations as stated above.

Example

Say your construction company owns a Crane.

Your balance sheet shows an original value of $15,000 and accumulated depreciation of $10,000. Thus, the net book value for the crane on your balance sheet is $5,000.

You sell the crane for $7,000.

To record this transaction, you show proceeds from the sale of the crane of $7,000 under investing activity.

Under the Cash Flow from Operations, you deduct gain on the sale of the crane of $2,000.

You need to think about how changes in these accounts affect cash in order to identify what way Net income needs to be adjusted.

Simple Logic can be used to calculate the impact of an increase or decrease in Current Assets.

When an asset increases during the year, cash must have been used to purchase the new asset.

Thus, a net increase in a current asset account actually decreases cash, so we need to subtract this reduction in cash from the net income.

For Example, if Accounts Receivable increases during the year - the company has sold more on credit during the year than it has collected in cash from customers.

The increase in Accounts receivable has been added to net income in the Income Statement without a real increase in cash and therefore, needs to be subtracted from Net Income.

The opposite is true if you see a decrease in accounts receivable.

Impact of a Current Asset Decrease

The opposite is true about current asset decreases.

If an asset account decreases, cash must have come in exchange for the Asset decrease.

For Example, if Accounts Receivable goes from $20,000 to $10,000, cash has come into the Business.

Similarly, If Inventory decreases from $20,000 to $10,000, Inventory has been sold and therefore $10,000 of Cash has come in.

Here’s a general rule of thumb when calculating the cash flow from Operations using the Cash Flow Statement Indirect Method.

Asset account increases: subtract the amount from Net income

Asset account decreases: add the amount to Net income

The liabilities section works the opposite of the assets section.

Impact of an increase in Current Liabilities

In other words, an increase in a Current liabilities needs to be added back into income.

Take accounts payable for example.

Accounts Payable in the balance sheet represent bills and invoices that the company has not yet paid - but have still recorded as an expense in the Income Statement.

This means that though Net Income is reported as decreased in the process, in reality - the cash has not been given out.

To see the real impact on Cash Flow, the increase in accounts payable must be added back to Net Income.

The opposite holds true for a decrease in accounts payable.

Impact of a decrease in Current Liabilities

A decrease in accounts payable represents that cash has actually been paid to vendors/suppliers.

In this case, Cash is deducted from Accounts Payable.

Here’s a general rule of thumb when calculating the cash flow from Operations using the Cash Flow Statement Indirect Method.

Liability account increases: add the amount to Net income

Liability account decreases: subtract the amount from Net income

The rules for cash flow adjustments to net income are:

The Cash Flow Statement Indirect method is used by most corporations, begins with a net income total and adjusts the total to reflect only cash received from operating activities.

These adjustments include deducting realized gains and other adding back realized losses to the net income total.

As a General Rule of Thumb-

• A Current Asset increase during the period decreases Cash Flow from Operating Activities. 
• A Current Asset decrease during the period increases cash flow from operating activities. 
• A Current Liability decrease during the period decreases Cash Flow from Operating Activities. 
• A Current Liability increase during the period increases Cash Flow from Operating Activities.

It would have been nice if we could think of the Net Income figure taken as it is as being a quick and easy way to judge a company's overall performance but when is life easy?

The Silver Lining here is that if you understand how the Cash Flow Statement Indirect Method works, you have just catapulted yourself forward into the world of Savvy Investors and Business Owners who can truly tell what is going on in a company.

How's that for a Superpower!

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