How to calculate cash flow with the indirect method

Revolut Contributor

 · August 05, 2020  · 08/05/2020

Liquidity is the lifeblood of a business, and so the premise of how to calculate cash flow is critical. The primary tools are the cash flow statement and the cash flow forecast. The latter is merely a prediction and often more straightforward than a full statement, which is the historic report for a given period. This post unravels how to prepare a cash flow statement, but we also explain forecasting here.

Cash flow is one of the ‘big three’ financial statements, alongside the income statement and balance sheet. Even though a small UK company isn’t obliged to publish its cash flow if it meets two of the criteria in The Companies Act 2006 (see below) this type of statement is still a valuable exercise.

  • Turnover of less than no more than £10.2 million
  • Balance sheet total of no more than £5.1 million
  • No more than 50 employees

What is the formula for cash flow?

There is no specific cash flow equation which governs how to calculate cash flow. That said, the process of putting together a cash flow statement will involve the creation of metrics which do. For instance, when you think about how to calculate net cash flow – a metric which reveals if the overall cash movement of the business is positive or negative – you will need this formula:

Net cash flow = Operating cash flow + Investing cash flow + Financing cash flow

The above equation relies upon an understanding of the three sections in a cash flow statement:

  • 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)

What is the formula for free cash flow?

Splitting cash flow into its three constituent sections opens the door to even more insightful metrics. For instance, free cash flow is a measure of both liquidity as well as profitability and is valued highly by investors. The basic formula is below, but we cover how to calculate free cash flow here.

Free cash flow (FCF) = Operating cash flow – Capital expenditure

How do you calculate total cash flow?

There are two ways to approach this task: the direct or indirect method, and we explore them in more detail here. The only difference between these methods is how to calculate operating cash flow. As the indirect version is easier and more popular, this is the route we take in this post.

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

The first task is to adjust the net income to remove non-cash transactions. For example, you add back the amount shown in the accounts for the depreciation of fixed assets. These depreciation costs are irrelevant in how to calculate cash flow, even though the value of any fixed assets paid for during the reporting period do get included in the investing section.

The next step is to add or subtract changes in the cash value of specific categories that relate to the operating activities. This is a tricky idea to get your head around, so buckle-up, folks, we’re going in…

These changes fall into two sub-categories: assets and liabilities. Asset accounts are things such as trade receivables or inventory; whereas liabilities would be trade payables or taxes owed. Think of the following four tips as your personal cash flow calculator:

  • Asset account increases: Subtract the amount from the net income
  • Asset account decreases: Add the amount to the net income
  • Liability account increases: Add the amount to the net income
  • Liability account decreases: Subtract the amount from the net income

Once you calculate the net effect of the various operating cash flows using the indirect method, you must apply the results of any changes to the investing and the financing cash flows over this period.

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

 

In the worked example above, the investing cash flow might be negative because Avocado Ltd paid for a new industrial lathe in 2019. The financing cash flow could be positive because it received funds from the issue of more shares in Avocado Ltd. Note that a business can choose whether to include payments of dividends to its own shareholders in the operating cash flow or the financing cash flow.

The final step is to combine the net income (i.e. once adjusted for all three cash flow activities) with the balance of cash and cash equivalents at the start of the reporting period. Job done.

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