The first section of a cash flow statement, known as cash flow from operating activities,
can be prepared using two different methods known as the direct method and the indirect
method. Here we will study the indirect method to calculate cash flows from operating
activities.
In indirect method, the net income figure from the income statement is used to calculate
the amount of net cash flow from operating activities. Since the income statement is
prepared on accrual basis in which revenue is recognized when earned and not when
received therefore net income does not represent the net cash flow from operating
activities and it is necessary to adjust earnings before interest and tax (EBIT) for those
items which effect net income although no actual cash is paid or received against them.
Formula
The following is the indirect method formula to calculate net cash flow from operating
activities:
Cash Flows from Operating Activities:
Net Income
+ Non-Cash Expenses:
(Depreciation, Depletion & Amortization Expense)
+ Non-Operating Losses:
(Loss on Sale of Non-Current Assets)
− Non-Operating Gains:
(Gain on Sale of Non-Current Assets)
+ Decrease in Current Assets:
(Accounts Receivable, Prepaid Expenses, Inventory etc.)
− Increase in Current Assets
+ Increase in Current Liabilities:
(Accounts Payable, Accrued Liabilities, Income Tax Payable etc.)
− Decrease in Current Liabilities
= Net Cash Flow from Operating Activities
The following example shows the format of the cash flows from operating activities
section of cash flows statement prepared using indirect method:
Example
Use the following information to calculate net cash flow from operating activities using
indirect method:
Net Income $7,000
Depreciation Expense 1,000
Increase in Accounts Receivable 4,400
Increase in Prepaid Rent 7,000
Decrease in Prepaid Insurance 1,300
Increase in Accounts Payable 14,000
Increase in Wages Payable 1,000
Decrease in Income Tax Payable 700
Gain on Sale of Equipment 1,800
The first section of a cash flow statement, known as cash flow from operating activities,
can be prepared using two different methods known as the direct method and the indirect
method. Here we will study the indirect method to calculate cash flows from operating
activities.
In indirect method, the net income figure from the income statement is used to calculate
the amount of net cash flow from operating activities. Since the income statement is
prepared on accrual basis in which revenue is recognized when earned and not when
received therefore net income does not represent the net cash flow from operating
activities and it is necessary to adjust earnings before interest and tax (EBIT) for those
items which effect net income although no actual cash is paid or received against them.
