Name the indirect method, model the cash flow statement step by step, show operating/investing/financing categories, and walk through a worked example.
The Indirect Method: Bridging Profit to Cash
Jennifer Kim, Sarah's CPA, sat down with her two completed statements. "We have your profit and your financial position," she said. "Now let's build the bridge between them — the Statement of Cash Flows using the indirect method. It starts with your net income and explains every difference between profit and actual cash."
Three Categories of Cash Flow
Cash from day-to-day business. Start with Net Income, add back non-cash expenses (depreciation), adjust for changes in working capital (receivables, payables, inventory).
Cash for long-term assets. Purchasing or selling equipment, buildings, vehicles, or investments. Cash out when buying, cash in when selling.
Cash from owners and creditors. Borrowing or repaying loans, issuing stock, paying dividends.
Step-by-Step: The Indirect Method
The Procedure
Step 1: Start with Net Income
Take the Net Income figure directly from the Income Statement. This is your starting point.
Step 2: Add Back Non-Cash Expenses
Depreciation and amortization reduced Net Income but required no cash. Add them back.
Step 3: Adjust for Changes in Working Capital
Compare beginning and ending Balance Sheet amounts for current assets and liabilities:
− Increase in current assets (AR, supplies, prepaid) = cash used
+ Decrease in current assets = cash freed up
+ Increase in current liabilities (AP, wages payable) = cash saved (not yet paid)
− Decrease in current liabilities = cash paid out
Step 4: List Investing Activities
Cash spent on or received from long-term assets. Compare equipment/buildings on the Balance Sheet.
Step 5: List Financing Activities
Cash from or to owners and creditors. Look at loans, stock, and dividends.
Step 6: Verify the Cash Change
Operating + Investing + Financing must equal the change in cash on the Balance Sheet.
Worked Example: Sarah's TechStart Solutions
Here is the data Sarah gathered from her Income Statement and comparative Balance Sheets.
Income Statement (month ended April 30):
| Service Revenue | $8,400 |
| Rent Expense | ($1,800) |
| Salary Expense | ($1,200) |
| Supplies Expense | ($650) |
| Depreciation Expense | ($300) |
| Net Income | $4,450 |
Balance Sheet Changes:
| Account | Beginning | Ending | Change |
|---|---|---|---|
| Cash | $9,500 | $10,300 | +$800 |
| Accounts Receivable | $4,300 | $6,400 | +$2,100 |
| Supplies | $800 | $1,200 | +$400 |
| Equipment | $9,000 | $12,000 | +$3,000 |
| Accounts Payable | $2,600 | $3,200 | +$600 |
| Notes Payable | $8,000 | $8,000 | — |
TechStart Solutions
Statement of Cash Flows (Indirect Method)
Month Ended April 30, 2024
Cash Flows from Operating Activities
Cash Flows from Investing Activities
Cash Flows from Financing Activities
Note: The ending cash should reconcile to the Balance Sheet. Any difference signals a classification error.
Key Insight
Sarah's Net Income was $4,450, but her operating cash flow was only $2,850. The $1,600 difference came from: customers who had not yet paid ($2,100 in receivables), supplies purchased but not yet used ($400), partially offset by bills she had not yet paid ($600 in payables) and depreciation that required no cash ($300). This is the story the Cash Flow Statement tells.
Discussion Prompt (3 minutes):
- Why would a bank care more about operating cash flow than net income?
- If Sarah's Accounts Receivable had decreased instead of increased, how would that affect operating cash flow?
- What does it mean that Sarah spent more on equipment than she generated from operations?
1. In the indirect method, what is the starting point for calculating cash flow from operating activities?
2. Depreciation expense of $300 appears on the Income Statement. How is it treated in the indirect cash flow method?
3. If Accounts Receivable increased by $2,100 during the period, how is this adjustment made in the indirect method?
4. Sarah purchased equipment for $3,000 cash. Where does this appear on the cash flow statement?
5. Sarah took out a $5,000 bank loan during the period. Where does this appear on the cash flow statement?
Phase 2 Learning Target
You should now understand the three categories of cash flow, how to start with Net Income and adjust for non-cash items and working capital changes, how to classify investing and financing activities, and how to verify that the net change in cash matches the Balance Sheet.