Preparing a Statement of Cash Flows Using the Indirect Method

Introduction

The statement of cash flows is a crucial financial statement that provides a detailed analysis of a company’s cash inflows and outflows over a specific period. It complements the income statement and balance sheet by offering insights into how a company generates and uses cash, which is vital for assessing its liquidity, solvency, and overall financial health. The indirect method is one of the two primary methods for preparing the statement of cash flows, the other being the direct method.

The indirect method starts with net income and adjusts for non-cash transactions, changes in working capital, and other cash flows to reconcile net income to net cash provided by operating activities. This tutorial will guide you through the process of preparing a statement of cash flows using the indirect method, with detailed explanations and examples.

Overview of the Statement of Cash Flows

The statement of cash flows is divided into three main sections:

Operating Activities: This section reports the cash generated or used in the core operations of the business. It includes adjustments to net income for non-cash items (e.g., depreciation and amortization) and changes in working capital (e.g., accounts receivable, accounts payable, and inventory).
Investing Activities: This section includes cash flows from the purchase and sale of long-term assets such as property, plant, and equipment, and investments in securities.
Financing Activities: This section captures cash flows related to changes in the company’s capital structure, such as issuing or repurchasing shares, borrowing or repaying debt, and paying dividends.

Step-by-Step Guide to Preparing the Statement of Cash Flows Using the Indirect Method

Step 1: Gather Required Information

To prepare a statement of cash flows using the indirect method, you will need the following information:

Income Statement for the current period.
Balance Sheets for the current and prior periods.
Additional information on significant transactions that do not appear directly in the income statement or balance sheets, such as non-cash transactions.

Step 2: Start with Net Income

The indirect method begins with net income, which is the starting point for calculating cash flows from operating activities. Net income can be found at the bottom of the income statement.

Example: Assume the net income for the current period is $100,000.

Step 3: Adjust for Non-Cash Items

Next, adjust net income for non-cash items that affect net income but do not involve actual cash flows. Common non-cash adjustments include:

Depreciation and Amortization: These are expenses that reduce net income but do not involve cash payments.
Impairment Losses: Write-downs of assets that reduce net income without affecting cash.
Stock-Based Compensation: Compensation expenses related to stock options.

Example: Assume depreciation expense for the current period is $10,000, and there are no other non-cash items.

Adjusted Net Income:

Net Income: $100,000
Add: Depreciation Expense: $10,000
Adjusted Net Income: $110,000

Step 4: Adjust for Changes in Working Capital

Changes in working capital accounts affect cash flow but are not reflected in net income. The main working capital accounts include:

Accounts Receivable: An increase in accounts receivable indicates that sales were made on credit and cash was not collected, reducing cash flow.
Inventory: An increase in inventory indicates that cash was used to purchase inventory, reducing cash flow.
Accounts Payable: An increase in accounts payable indicates that purchases were made on credit and cash was not paid out, increasing cash flow.
Accrued Expenses: Similar to accounts payable, an increase in accrued expenses increases cash flow.

Example: Assume the following changes in working capital accounts:

Accounts Receivable increased by $5,000.
Inventory increased by $7,000.
Accounts Payable increased by $4,000.
Accrued Expenses increased by $2,000.

Adjusted Net Income with Working Capital Changes:

Adjusted Net Income: $110,000
Less: Increase in Accounts Receivable: $5,000
Less: Increase in Inventory: $7,000
Add: Increase in Accounts Payable: $4,000
Add: Increase in Accrued Expenses: $2,000
Net Cash Provided by Operating Activities: $104,000

Step 5: Calculate Cash Flows from Investing Activities

Cash flows from investing activities include transactions involving long-term assets. Common cash flows in this section include:

Purchase of Property, Plant, and Equipment (PP&E): Cash outflows for buying long-term assets.
Sale of PP&E: Cash inflows from selling long-term assets.
Purchase and Sale of Investments: Cash inflows and outflows related to investment securities.

Example: Assume the following investing activities:

Purchased equipment for $20,000.
Sold an old piece of equipment for $5,000.

Net Cash Used in Investing Activities:

Purchase of Equipment: $(20,000)
Sale of Equipment: $5,000
Net Cash Used in Investing Activities: $(15,000)

Step 6: Calculate Cash Flows from Financing Activities

Cash flows from financing activities include transactions related to changes in the company’s capital structure. Common cash flows in this section include:

Issuance of Common Stock: Cash inflows from issuing new shares.
Repurchase of Common Stock: Cash outflows for buying back shares.
Borrowing and Repaying Debt: Cash inflows from taking loans and outflows for repaying loans.
Payment of Dividends: Cash outflows for paying dividends to shareholders.

Example: Assume the following financing activities:

Issued common stock for $30,000.
Repaid a loan of $10,000.
Paid dividends of $8,000.

Net Cash Provided by Financing Activities:

Issuance of Common Stock: $30,000
Repayment of Loan: $(10,000)
Payment of Dividends: $(8,000)
Net Cash Provided by Financing Activities: $12,000

Step 7: Combine All Sections

Finally, combine the net cash flows from operating, investing, and financing activities to determine the net increase or decrease in cash for the period. Add this amount to the beginning cash balance to find the ending cash balance.

Example: Assume the beginning cash balance is $50,000.

Net Increase in Cash:

Net Cash Provided by Operating Activities: $104,000
Net Cash Used in Investing Activities: $(15,000)
Net Cash Provided by Financing Activities: $12,000
Net Increase in Cash: $101,000

Ending Cash Balance:

Beginning Cash Balance: $50,000
Net Increase in Cash: $101,000
Ending Cash Balance: $151,000

Example Statement of Cash Flows Using the Indirect Method

Below is a complete example of a statement of cash flows using the indirect method:

XYZ Company
Statement of Cash Flows
For the Year Ended December 31, 20XX

Cash Flows from Operating Activities

Net Income: $100,000
Adjustments for Non-Cash Items:
  Depreciation Expense: $10,000
Changes in Working Capital:
  Increase in Accounts Receivable: $(5,000)
  Increase in Inventory: $(7,000)
  Increase in Accounts Payable: $4,000
  Increase in Accrued Expenses: $2,000
Net Cash Provided by Operating Activities: $104,000

Cash Flows from Investing Activities

Purchase of Equipment: $(20,000)
Sale of Equipment: $5,000
Net Cash Used in Investing Activities: $(15,000)

Cash Flows from Financing Activities

Issuance of Common Stock: $30,000
Repayment of Loan: $(10,000)
Payment of Dividends: $(8,000)
Net Cash Provided by Financing Activities: $12,000

Net Increase in Cash

$101,000

Cash at Beginning of Period

$50,000

Cash at End of Period

$151,000

Detailed Explanation of Key Components

Non-Cash Adjustments

Depreciation and Amortization: These expenses are added back to net income because they represent non-cash charges. Depreciation refers to the allocation of the cost of tangible assets over their useful lives, while amortization applies to intangible assets.
Impairment Losses: These losses occur when an asset’s carrying amount exceeds its recoverable amount. Impairment losses are added back to net income as they do not involve actual cash outflows.
Stock-Based Compensation: This expense is related to stock options granted to employees and is added back to net income because it does not involve cash outflows.

Changes in Working Capital

Accounts Receivable: An increase in accounts receivable means that sales were made on credit, reducing cash flow. Conversely, a decrease in accounts receivable indicates cash was collected from customers, increasing cash flow.
Inventory: An increase in inventory suggests that cash was used to purchase inventory, reducing cash flow. A decrease in inventory indicates that less cash was spent on inventory purchases, increasing cash flow.
Accounts Payable: An increase in accounts payable means that purchases were made on credit, increasing cash flow. A decrease in accounts payable indicates that cash was used to pay suppliers, reducing cash flow.
Accrued Expenses: An increase in accrued expenses means that expenses were incurred but not yet paid, increasing cash flow. A decrease in accrued expenses indicates that cash was used to pay these expenses, reducing cash flow.

Investing Activities

Purchase of Property, Plant, and Equipment (PP&E): Cash outflows for buying long-term assets are subtracted from cash flow.
Sale of PP&E: Cash inflows from selling long-term assets are added to cash flow.
Purchase and Sale of Investments: Cash outflows for buying investment securities are subtracted from cash flow, while cash inflows from selling investments are added to cash flow.

Financing Activities

Issuance of Common Stock: Cash inflows from issuing new shares are added to cash flow.
Repurchase of Common Stock: Cash outflows for buying back shares are subtracted from cash flow.
Borrowing and Repaying Debt: Cash inflows from taking loans are added to cash flow, while cash outflows for repaying loans are subtracted from cash flow.
Payment of Dividends: Cash outflows for paying dividends to shareholders are subtracted from cash flow.

Practical Considerations

Common Mistakes to Avoid

Double Counting: Ensure that adjustments for non-cash items and changes in working capital are made only once. Double counting can distort the cash flow statement.
Ignoring Non-Cash Transactions: Non-cash transactions such as depreciation, amortization, and stock-based compensation must be adjusted to avoid inaccuracies in the cash flow statement.
Incorrect Classification: Ensure that cash flows are classified correctly into operating, investing, and financing activities. Misclassification can lead to incorrect analysis and decision-making.

Analyzing the Statement of Cash Flows

Operating Cash Flow: Positive cash flow from operating activities indicates that the company is generating sufficient cash from its core operations to sustain and grow its business. Negative cash flow from operating activities may indicate potential liquidity issues.
Investing Cash Flow: Negative cash flow from investing activities is common for growing companies as they invest in long-term assets. However, consistently negative cash flow from investing activities without corresponding growth in revenue and profits may raise concerns.
Financing Cash Flow: Positive cash flow from financing activities may indicate that the company is raising capital through debt or equity to fund its operations or expansion. Negative cash flow from financing activities may indicate that the company is repaying debt, paying dividends, or buying back shares.

Conclusion

Preparing a statement of cash flows using the indirect method involves starting with net income and making adjustments for non-cash items and changes in working capital. This method provides valuable insights into a company’s cash flow from operating, investing, and financing activities, helping stakeholders assess the company’s liquidity, solvency, and overall financial health.