Calculating Cash Flows
There are two different methods that can be used to report the cash flows of operating activities. There is the direct method and the indirect method.
Calculating cash flow
The indirect method adjusts net income (rather than adjusting individual items in the income statement).
Indirect Method
The indirect method adjusts net income (rather than adjusting individual items in the income statement) for:
- changes in current assets (other than cash) and current liabilities, and
- items that were included in net income but did not affect cash.
The indirect method uses net income as a starting point, makes adjustments for all transactions for non-cash items, then adjusts for all cash-based transactions. An increase in an asset account is subtracted from net income, and an increase in a liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions. The following rules can be followed to calculate cash flows from operating activities:
- Decrease in non-cash current assets are added to net income;
- Increase in non-cash current asset are subtracted from net income;
- Increase in current liabilities are added to net income;
- Decrease in current liabilities are subtracted from net income;
- Expenses with no cash outflows are added back to net income (depreciation and/or amortization expense are the only operating items that have no effect on cash flows in the period);
- Revenues with no cash inflows are subtracted from net income;
- Non operating losses are added back to net income;
- Non operating gains are subtracted from net income.
Under the indirect method, since net income is a starting point in measuring cash flows from operating activities, depreciation expenses must be added back to net income. So, depreciation expense is shown (or captioned) on the statement of cash flows. Also, in the indirect method cash paid for taxes and cash paid for interest must be disclosed.
Direct Method Versus Indirect Method
Consider a firm reporting revenues of $125,000. During the reporting period, the firm's accounts receivables increased by $36,000. Therefore, cash collected from these revenues was $89,000. Operating expenses reported during the period were $85,000, but accounts payable increased during the period by $5,000. Therefore, cash operating expenses were only $80,000. The net cash flow from operating activities, before taxes, would be:
Cash flow from revenue: 89,000
Cash flow from expenses: (80,000)
Net cash flow: 9,000
The indirect method would find these cash flows as follows.
Revenue: 125,000
Expenses: (85,000)
Net Income: 40,000
The adjustments for cash flow would then be made to this amount of net income. $36,000 would be subtracted due to the increase in accounts receivable, and $5,000 would be added due to the increase in accounts payable. This leaves us with the amount of $9,000 for net income.