How to Prepare a Cash Flow Statement Using the Indirect Method

A cash flow statement shows how a company generates and uses cash over a specific period. This financial report is fundamental to understanding a company’s liquidity and solvency, offering a different perspective than the income statement or balance sheet. It reconciles net income with actual cash received and disbursed. Preparing this statement using the indirect method involves starting with net income and adjusting it for non-cash items and changes in working capital accounts.

Key Components of a Cash Flow Statement

A cash flow statement has three sections. The operating activities section details cash generated from a company’s primary business operations. This section often undergoes the most adjustments when using the indirect method, as it converts accrual-based net income to a cash basis.

The investing activities section reports cash flows related to the acquisition and disposal of long-term assets. These assets include property, plant, equipment, and investments in other companies. Understanding these cash flows helps assess a company’s growth strategies and its ability to expand or maintain operational capacity.

The financing activities section focuses on cash flows related to debt, equity, and dividends. This includes transactions involving borrowing or repaying loans, issuing or repurchasing stock, and paying dividends to shareholders. This section reveals how a company funds its operations and growth, and how it returns value to owners.

Essential Financial Data for Preparation

Preparing a cash flow statement using the indirect method requires specific financial information. The income statement for the period provides the starting point of net income. This accrual-based figure must be converted to a cash basis for operating activities.

Comparative balance sheets are essential, showing the financial position at the beginning and end of the period. Changes in asset, liability, and equity accounts between these balance sheets provide data for adjustments in all three sections.

Notes to the financial statements often provide further details. These might include specifics on non-cash transactions, such as the exchange of assets or the issuance of stock for non-cash consideration, which are not directly reflected in the income statement or balance sheet changes.

Preparing Cash Flows from Operating Activities (Indirect Method)

The process of preparing cash flows from operating activities using the indirect method begins with the net income figure reported on the income statement. This amount, calculated under accrual accounting principles, includes non-cash revenues and expenses that do not reflect actual cash movements. The initial step involves adjusting this net income to remove the impact of these non-cash items.

Non-cash expenses, such as depreciation, amortization, and impairment charges, are added back to net income. Depreciation, for instance, systematically allocates the cost of a tangible asset over its useful life but does not involve a cash outlay in the current period. Similarly, amortization of intangible assets or impairment losses on assets reduce reported earnings without a corresponding cash disbursement, requiring their addition back.

Adjustments are also made for non-operating gains and losses that appear on the income statement. A gain on the sale of an asset, for example, is subtracted from net income because the cash received from the sale is fully reported in the investing activities section, and the gain itself is a non-cash adjustment to profit. Conversely, a loss on the sale of an asset is added back, as the cash effect is also captured in investing activities, and the loss reduced net income without a corresponding cash outflow from operations.

Changes in current operating assets and liabilities further adjust net income to arrive at cash flow from operations. An increase in a current operating asset, such as accounts receivable, signifies that revenue was recognized but cash was not yet collected, so this increase is subtracted from net income. Conversely, a decrease in accounts receivable means cash was collected from previous sales, which is added back.

An increase in inventory implies cash was used to purchase more goods than sold, leading to a subtraction from net income. A decrease in inventory, however, means more goods were sold than purchased, generating cash and requiring an addition. Similarly, an increase in a current operating liability, like accounts payable, indicates that expenses were incurred but not yet paid in cash, effectively increasing cash on hand, so this increase is added.

A decrease in accounts payable, conversely, means cash was used to pay off liabilities, necessitating a subtraction. Prepaid expenses follow a similar logic to other current assets; an increase means cash was paid upfront for future expenses, reducing current cash flow and requiring a subtraction. Accrued expenses, like accounts payable, are liabilities; an increase means expenses were incurred but cash has not yet been paid, leading to an addition to net income.

Preparing Cash Flows from Investing and Financing Activities

Cash flows from investing activities reflect a company’s decisions regarding its long-term assets. These transactions involve the purchase or sale of property, plant, and equipment, as well as investments in other entities.

When a company purchases a long-term asset, such as new machinery, the cash outflow is recorded as a negative amount in the investing section. Conversely, the sale of a long-term asset generates a cash inflow, which is reported as a positive amount. This section also includes cash flows from the purchase or sale of investment securities.

Cash flows from financing activities detail how a company raises and repays capital. This involves transactions related to debt, equity, and dividends. Changes in long-term debt accounts on the balance sheet indicate cash inflows from issuing new debt or cash outflows from repaying existing debt.

Changes in equity accounts reveal cash movements related to stock. Issuing new shares results in a cash inflow, while repurchasing stock leads to a cash outflow. Dividend payments to shareholders also represent a cash outflow, reflecting the distribution of profits to owners.

Completing the Cash Flow Statement

After preparing the cash flows from operating, investing, and financing activities, consolidate these three sections into a comprehensive statement. The cash flow from each activity type is summed to determine the net increase or decrease in cash for the reporting period.

Once the net change in cash is calculated, it is added to the beginning cash balance, which is obtained from the prior period’s balance sheet. This calculation yields the ending cash balance for the current period.

The ending cash balance derived from the cash flow statement must precisely match the cash balance reported on the current period’s balance sheet. This reconciliation checks the statement’s accuracy and completeness. Any discrepancy indicates an error, requiring a review of the preparation steps.