What is the indirect method of cash flows?
The indirect method is one of two accounting treatments used to create a cash flow statement. The following are important aspects of this method:
- The indirect method is used when the company is using the accrual basis of accounting instead of cash.
- The indirect method uses increases and decreases in balance sheet line items to modify the operating section of the cash flow statement from the accrual method to the cash method of accounting.
- The indirect method is the most commonly used method for the cash flow statement.
- This method is also preferred because the information is readily available by using a comparative incomes statement and balance sheet.
Indirect method vs. direct method
The difference between an indirect and direct cash flow statement is in how they prepare the operating activities section of the statement of cash flows:
- Indirect cash flow statement: The indirect method starts with net income from the income statement and adjusts for non-cash items (depreciation, working capital, non-operating gains/losses) to arrive at the net cash provided by or used in operating activities.
- Direct cash flow statement: The direct method directly reports the actual cash inflows and outflows from operating activities.
Why use an indirect method for the cash flow statement
Here are reasons why the indirect method is used for preparing the cash flow statement:
- Availability of information: The indirect method relies on readily available financial statements, such as the income statement and balance sheet.
- Simplicity: The indirect method is generally considered simpler and less time-consuming compared to the direct method. It involves adjusting net income using readily available information which is particularly beneficial for smaller businesses or those with limited resources for complex financial analysis.
- Compliance: Many accounting standards and frameworks, such as Generally Accepted Accounting Principles (GAAP), allow or even require the use of the indirect method.
- Comparative analysis: Since the indirect method aligns with widely accepted financial statements, it is easier to compare cash flow data over time or across organizations, providing valuable insights into trends and performance.
It’s important to note that while the indirect method is commonly used, both the indirect and direct methods can provide valuable information about a company’s cash flow. The choice of method ultimately depends on factors such as reporting requirements, available data, and the specific needs of the organization or users of the financial statements.
How to create an indirect cash flow statement
The cash flow statement is broken up into three sections: Operating Activities, Investing Activities, and Financing Activities.
- Operating activities: This includes anything needed for business operations.
- Investing activities: This includes any type of investing the company is doing, such as purchasing equipment or assets for the company or buying and selling stocks.
- Financing activities: This includes all action the company has taken to finance its operations, such as, proceeds from a line of credit, repayment of a loan, issuing stock, or repurchase of company stock.
How to prepare an indirect cash flow statement
Here’s a general outline on how to do an indirect cash flow statement:
Step 1: Download the indirect cash flow statement Excel template.
Step 2: Determine the time period for the indirect cash flow statement.
Step 3: Start with net income from the income statement.
Step 4: List out operating activities.
- List out non-cash operating activities.
- List out all changes in cash operating activities.
- List out all changes in liabilities.
Step 5: Add or subtract investing activities.
Step 6: Add or subtract financing activities.
Step 7: Calculate ending cash balance.
You can find more detailed instructions on how to use the indirect method to prepare a cash flow statement when you download this template.
What is the purpose of an indirect cash flow statement?
The purpose of an indirect cash flow statement is to reconcile the net income reported on the income statement with the cash generated or used in operating activities during a specific period. It provides valuable information about the sources and uses of cash within a business, focusing on the operating activities rather than the net cash position alone.
What information does an indirect cash flow statement include?
An indirect cash flow statement includes the following key information:
- Net income
- Adjustments for non-cash expenses
- Adjustments for changes in working capital
- Non-operating gains/losses
- Net cash provided by or used in operating activities
Why is the indirect method preferred for cash flow statements?
The indirect method is more commonly used as it is less time-consuming since it relies on readily available financial statements. The indirect method also allows for easier comparative analysis between different periods or companies.
What are the limitations of the indirect method?
While the indirect method for cash flows is widely used, it does have certain limitations:
- Lack of detail: The indirect method does not provide a detailed breakdown of cash inflows and outflows from specific operating activities.
- Difficulty in identifying non-operating items: The indirect method adjusts for non-operating gains or losses, but it may be challenging to differentiate between operating and non-operating items.
- Reliance on accrual accounting: Accrual accounting can introduce timing differences between recognizing revenue or expenses and their actual cash inflows or outflows, potentially leading to discrepancies between reported net income and cash flow from operating activities.
- Difficulty in assessing liquidity and solvency: The indirect method does not explicitly highlight the company’s ability to meet short-term obligations or generate cash for investments and debt repayments.
- Non-cash items limitations: The indirect method adjusts for non-cash items such as depreciation and changes in working capital. While these adjustments aim to reconcile net income and cash flows, they may not capture all non-cash activities or changes in the company’s financial position.