How to Prepare Statement of Cash Flows: Indirect Method

A Statement of Cash Flows (SCF) provides a clear picture of how a company generates and uses its cash over a specific period. This financial statement is important for understanding an entity’s ability to meet short-term obligations and fund its operations and growth. It complements the income statement and balance sheet by focusing on actual cash movements, rather than just revenues and expenses recognized under accrual accounting. While there are two methods to prepare the SCF—the direct and indirect methods—this article will focus on the widely used indirect method. The indirect method begins with net income and adjusts it to reflect the true cash inflows and outflows from operating activities.

Gathering Necessary Financial Data

Preparing a Statement of Cash Flows using the indirect method requires specific financial information. The primary sources for this data are a company’s comparative balance sheets and its income statement.

Comparative balance sheets, which present financial positions at two different points in time, are essential. These allow for the identification of changes in asset, liability, and equity accounts, which often correspond to cash inflows or outflows. For instance, an increase in a non-cash asset account or a decrease in a liability account generally signifies a cash outflow, while the opposite usually indicates a cash inflow.

The income statement provides the net income (or loss) figure, which serves as the starting point for the operating activities section. This figure represents the company’s profitability based on accrual accounting, but it includes non-cash items that need to be adjusted. Information regarding non-cash transactions, such as depreciation, amortization, and gains or losses from the sale of assets, is also essential. These details are often found in the notes to the financial statements or from internal accounting records.

Calculating Cash Flows from Operating Activities

The operating activities section, when prepared using the indirect method, begins with the net income reported on the income statement. This starting point reflects a company’s profitability based on the accrual method of accounting, where revenues are recognized when earned and expenses when incurred, regardless of when cash changes hands. To convert this accrual-based net income into cash flow from operations, several adjustments are necessary for non-cash items and changes in working capital accounts.

Non-cash expenses, such as depreciation and amortization, are added back to net income because they reduce reported profit but do not involve an actual outflow of cash during the period. Depreciation, for example, allocates the cost of a tangible asset over its useful life, impacting net income without using cash in the current period. Similarly, amortization spreads the cost of an intangible asset over time.

Gains and losses from the sale of long-term assets also require adjustment because they are typically classified under investing activities. A gain on the sale of an asset is subtracted from net income because it increased net income, but the cash received from the sale itself is reported in the investing section. Conversely, a loss on the sale of an asset is added back to net income as it reduced net income, but the cash effect of the sale is captured elsewhere.

Changes in current assets and liabilities, collectively known as working capital, significantly impact operating cash flow. An increase in a current asset account, such as accounts receivable or inventory, means that cash was tied up or not yet collected, thus decreasing cash flow from operations. For example, if accounts receivable increases, it implies that sales were made on credit, increasing net income but not cash. Therefore, an increase in current assets like accounts receivable, inventory, or prepaid expenses is subtracted from net income.

Conversely, a decrease in a current asset account indicates that cash was collected or freed up, increasing cash flow. For current liabilities, the effect is opposite: an increase in a current liability, such as accounts payable or accrued expenses, signifies that cash was conserved because expenses were incurred but not yet paid, thereby increasing cash flow. A decrease in current liabilities, however, indicates cash was used to pay off obligations, reducing cash flow from operations.

Determining Cash Flows from Investing and Financing Activities

Beyond operating activities, the Statement of Cash Flows categorizes cash movements into investing and financing sections, which are prepared similarly regardless of whether the direct or indirect method is used for operations. These sections provide insight into how a company manages its long-term assets and its capital structure.

Investing activities encompass cash flows related to the purchase and sale of long-term assets and investments. Cash outflows typically include the acquisition of property, plant, and equipment (often referred to as capital expenditures), and the purchase of investments in other companies or marketable securities. Cash inflows arise from the sale of these long-term assets, such as receiving proceeds from selling old equipment or divesting a business segment.

Financing activities detail cash flows generated from or used to repay debt and equity. Cash inflows in this section primarily result from issuing new shares of stock or borrowing funds through loans or bonds. Cash outflows include repaying the principal on loans, repurchasing the company’s own stock (treasury stock), and paying cash dividends to shareholders. These activities reflect a company’s strategies for funding its operations and distributing returns to its owners.

Completing the Cash Flow Statement

Once the cash flows from operating, investing, and financing activities have been calculated, the final step involves combining these amounts to determine the net increase or decrease in cash for the period. This aggregation provides a comprehensive view of the company’s overall cash movement.

This net change in cash is then added to the beginning cash balance, which is obtained from the prior period’s balance sheet. The resulting figure should precisely match the ending cash balance reported on the current period’s balance sheet. This reconciliation serves as an important check of the statement’s accuracy. The Statement of Cash Flows is typically presented with the operating activities section first, followed by investing and financing activities, culminating in the reconciliation of beginning and ending cash balances.