What is the Cash Flow Statement Indirect Method?
The indirect method is a way of preparing the cash flow statement that starts with the net income of the company and adjusts it for non-cash items, such as depreciation, amortization, and deferred taxes, and for changes in working capital items, such as accounts receivable, accounts payable, and inventory. The resulting number is the cash flow from operating activities. This number is then adjusted for cash flows from investing and financing activities to arrive at the net increase or decrease in cash and cash equivalents for the period.
Advantages and Disadvantages of the Indirect Method
The indirect method has both advantages and disadvantages. One of the main advantages is that it is easier and less time-consuming to prepare than the direct method, which requires detailed information about cash receipts and payments. Additionally, the indirect method provides more detailed information about the sources and uses of cash than the direct method.
However, the indirect method has some disadvantages as well. One of the main criticisms of this method is that it can obscure the true sources and uses of cash in the business. Additionally, because it relies on adjustments to the net income figure, it can be subject to manipulation by companies seeking to present a more favorable cash flow picture.
Preparing the Indirect Method Cash Flow Statement
To prepare the indirect method cash flow statement, you will need to start with the net income figure for the period, which can be found on the income statement. From there, you will need to make adjustments for non-cash items, such as depreciation and amortization, and changes in working capital items, such as accounts receivable, accounts payable, and inventory.
Once you have calculated the cash flow from operating activities, you will need to adjust for cash flows from investing and financing activities. This can include items such as the purchase or sale of property, plant, and equipment, the issuance or repayment of debt, and the payment of dividends.
Finally, you will arrive at the net increase or decrease in cash and cash equivalents for the period. This number can be compared to the beginning and ending cash balance figures to get a clearer picture of the company's cash position.
Example of Cash flow Direct Method
ABC Corporation
Statement of Cash Flows (Indirect Method)
For the Year Ended December 31, 2022
| Operating Activities | ||
| Net Income | $100,000 | |
| Adjustments to reconcile net income to net cash provided by operating activities: | ||
| Depreciation and Amortization Expense | $20,000 | |
| Increase in Accounts Receivable | ($10,000) | |
| Increase in Inventory | ($5,000) | |
| Increase in Accounts Payable | $8,000 | |
| Decrease in Prepaid Expenses | $2,000 | |
| Net Cash Provided by Operating Activities | $115,000 | |
| Investing Activities | ||
| Purchase of Property, Plant, and Equipment | ($50,000) | |
| Net Cash Used in Investing Activities | ($50,000) | |
| Financing Activities | ||
| Issuance of Common Stock | $10,000 | |
| Payment of Dividends | ($30,000) | |
| Net Cash Used in Financing Activities | ($20,000) | |
| Net Increase in Cash and Cash Equivalents | $45,000 | |
| Cash and Cash Equivalents, Beginning of Year | $20,000 | |
| Cash and Cash Equivalents, End of Year | $65,000 |
Conclusion
In conclusion, the indirect method is a widely used way of preparing the cash flow statement that can provide valuable insights into a company's cash position. While it has its advantages and disadvantages, understanding this method is essential for any business owner, investor, or financial analyst. By following the steps outlined in this article, you can prepare a comprehensive and accurate cash flow statement using the indirect method.
