Cash Flow from Operating Activities Indirect Method

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 Expense1,000
Increase in Accounts Receivable4,400
Increase in Prepaid Rent7,000
Decrease in Prepaid Insurance1,300
Increase in Accounts Payable14,000
Increase in Wages Payable1,000
Decrease in Income Tax Payable700
Gain on Sale of Equipment1,800

Solution:

Cash Flows from Operating Activities:
Net Income$7,000
Depreciation Expense1,000
Gain on Sale of Equipment−1,800
Increase in Accounts Receivable−4,400
Increase in Prepaid Rent−7,000
Decrease in Prepaid Insurance1,300
Increase in Accounts Payable14,000
Increase in Wages Payable1,000
Decrease in Income Tax Payable−700
Net Cash Flow from Operating Activities$10,400

Written by Irfanullah Jan