What is the indirect method of preparing a cash flow statement?

Revolut Contributor

 · August 05, 2020  · 08/05/2020

When you need to prepare a cash flow statement for a business over a given period, there are two different ways to calculate the actual cash flow: indirect method and the direct method.

As its name suggests, the direct method takes the opening cash balance. You must then list every cash inflow or outflow over the same timeframe to show their cumulative effect on the cash reserves of the business. With an indirect cash flow statement, you take the net profits for the reporting period and adjust that figure based on increases or decreases to specific values on the balance sheet. This process also includes the removal of entries related to depreciation and amortisation.

What is the difference between the direct and indirect methods of cash flow statement?

To answer this, you will first need to grasp that a cash flow statement has three sections:

  • Operating cash flow (i.e. activities related to operations e.g. sales revenue or supplier costs)
  • Investing cash flow (i.e. activities related to investment e.g. purchase or sale of machinery)
  • Financing cash flow (i.e. activities related to providers of capital e.g. long-term loans)

Each section gets calculated separately, and these results are then applied to the opening cash balance of the reporting period to reveal the net effect on the cash position of the business. The only difference between the direct and indirect methods is how to calculate the operating cash flow section.

We cover the nuances of what to include in the operating cash flow (OCF) here. The other two sections of the cash flow statement are identical for either method.

How do you calculate an indirect cash flow statement?

Most businesses prepare their accounts on an accrual basis, which means they must show new revenue when it is earned, rather than when they receive payment. The cash flow statement repackages these financial transactions to show how cash moves, rather than the moment when the revenue or expenses are formally recognised.

With the indirect method, cash flow is calculated by taking the value of the net income (i.e. net profit) at the end of the reporting period. You then adjust this net income value based on figures within the balance sheet and strip-out the effect of non-cash movements shown on the profit and loss statement.

The first step is to adjust net income to remove non-cash transactions. For example, the amount shown in the accounts for depreciation of fixed assets is added back. The reason is because the cost of these assets is spread over several years to reflect when the business derives their benefit. While fixed assets paid for during the reporting period do get included in the investing cash flow category, the depreciation costs are irrelevant to cash flow.

The next stage is to add or subtract the changes in the cash value of specific categories that relate to operating activities. Once you calculate the net effect of these operating cash flows using the indirect method, the final step is to apply the effect of the changes due to investing and financing cash flows.

We cover how to calculate cash flow in more detail here, and show a simple example of the indirect method below:

Avocado Ltd: fictional cash flow statement for the year ended 31 Dec 2019

Row

Description

£

 

Operating cash flow calculation

 

A

Net income

100k

 

Adjustments for:

 
 

Depreciation and amortisation

10k

 

(Increase) or decrease in current assets

 
 

Trade receivables 

(10k)

 

Inventory

5k

 

Increase or (decrease) in current liabilities

 
 

Trade payables

10k

B

Operating cash flow
(i.e. Value of net income from Row A after the above adjustments)

115k

C

Investing cash flow 

(10k)

D

Financing cash flow 

20k

E

Net change to the balance of cash and cash equivalents for the period
(i.e. Sum of rows B+C+D)

125k

F

Balance of cash and cash equivalents at the start of the period

75k

 

Balance of cash and cash equivalents at the end of the period

(i.e. Sum of rows E+F) 

£200k

 

Why use the indirect method of cash flows?

The indirect cash flow method is more straightforward, as it doesn’t require details of every cash movement, such as the date and amount of cash received when a customer pays for goods. All the figures needed for the cash flow indirect method are on the income statement and the balance sheet.

A business will typically need to reconcile its balance sheet as well as create line-by-line transactions for every cash movement if it opts to use the direct method. The result of this situation is that it would perform the primary calculations of the indirect method as well as the direct method. Why do both?

The benefit of the direct method is that it is more precise, assuming the transaction details for cash paid or received are accurate. This precision makes the direct method wise if a business is in distress, and must calculate cash flow regularly. For most scenarios, the indirect method is the practical choice.

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