Statement of Cash Flows Using the Indirect Method
The statement of cash flows explains how a company's cash balance changed over a period. While the income statement shows profitability on an accrual basis, the cash flow statement answers a different question: where did the cash actually come from, and where did it go?
The indirect method starts with net income and works backward to figure out how much cash operations actually generated. Investing and financing activities are reported separately to complete the full picture. By the end, the three sections sum to the net change in cash, which should reconcile to the balance sheet.
Construction of the Statement
Building a complete statement of cash flows follows a specific sequence:
- Start with net income from the income statement. This is the top line of the operating section.
- Adjust net income for non-cash items and changes in current assets and liabilities to arrive at cash flows from operating activities.
- Report cash flows from investing activities, which cover purchases and sales of long-term assets, investments, and loans made to or collected from other entities.
- Report cash flows from financing activities, which cover stock issuances or repurchases, long-term debt borrowings or repayments, and dividend payments.
- Sum all three sections to get the net increase or decrease in cash for the period.
- Add the net change to the beginning cash balance to arrive at the ending cash balance. This ending balance must match the cash (and cash equivalents) reported on the balance sheet.
Cash equivalents are highly liquid short-term investments (like Treasury bills maturing within 90 days). They're grouped with cash in both the beginning and ending balances.
Adjusting Net Income (Operating Section)
This is the core of the indirect method. You're converting accrual-basis net income into a cash-basis number. Each adjustment has a clear logic behind it.
Non-cash expenses: Add back depreciation and amortization. These reduced net income but didn't require any cash outflow. For example, if depreciation expense was , you add back to net income.
Gains and losses on asset sales: Subtract gains and add back losses on sales of long-term assets. The actual cash from the sale gets reported in the investing section, so you need to remove the gain or loss from operating activities to avoid double-counting. A gain on equipment sold would be subtracted here; the full cash proceeds appear under investing.
Changes in current assets and liabilities: This is where students tend to get tripped up. The rules follow a pattern:
- Current assets (accounts receivable, inventory, prepaid expenses): An increase means cash was used up or not yet collected, so you subtract it. A decrease means cash was freed up, so you add it.
- Current liabilities (accounts payable, accrued expenses, unearned revenue): An increase means you received cash or haven't paid yet, so you add it. A decrease means cash went out the door, so you subtract it.
Think of it this way: if accounts receivable went up by , that's in revenue you recorded but haven't collected in cash yet. So you subtract it. If accounts payable went up by , that's in expenses you recorded but haven't paid in cash yet. So you add it.
After all these adjustments, you arrive at net cash provided by (or used in) operating activities.
Classification of Investing and Financing Activities
Investing activities involve long-term assets and investments:
- Cash outflows: Purchasing property, plant, and equipment (machinery, vehicles, buildings); buying long-term investments (stocks, bonds of other companies); making loans to other entities
- Cash inflows: Selling long-term assets or investments; collecting principal on loans made to others
Financing activities involve the company's own debt and equity:
- Cash inflows: Issuing common or preferred stock; borrowing through long-term debt (bonds, notes payable)
- Cash outflows: Repurchasing stock (treasury stock); repaying long-term debt principal; paying dividends to shareholders
Each section reports its own net cash flow as a separate line item on the statement.
Additional Financial Analysis
Two useful metrics come directly from the cash flow statement:
Free cash flow measures how much cash a company generates beyond what it needs to maintain or expand its asset base. The formula is:
A positive free cash flow means the company has surplus cash available for dividends, debt repayment, or new investments.
Working capital changes (current assets minus current liabilities) also deserve attention. Large swings in working capital can signal shifts in how efficiently a company manages its short-term operations, even when net income looks stable.