How to prepare Cash Flow Statement using Indirect Method

Indirect cash flow statement is divided into three areas:

  • Operating activities: Cash inflow/outflow from business activities such as sales, royalties, commissions, fines, lawsuits, supplier and lender invoices, and payroll.
  • Investing activities: Cash inflow/outflow from sale/purchase of long term assets (CAPEX/Capital expenditures). Eg: purchase or sale of fixed assets/securities issued by other entities.
  • Financing activities: Cash inflow/outflow with regard to equity or borrowings of a business. Eg; sale of company shares, repurchase of shares and dividend payments.

 

Operating activities

Steps for calculating cash flow from operations using the indirect method:

  1. Start with net income.
  2. Add back non-cash expenses.
    • (Such as depreciation and amortization)
  3. Adjust for gains and losses on sales on assets.
    • Add back losses
    • Subtract out gains
  4. Account for changes in all non-cash Current Assets.
    • Add decrease in current assets (Accounts Receivable, Prepaid Expenses, Inventory etc.)
    • Subtract increase in current assets
  5. Account for changes in all non cash Current Liabilities (except notes payable and dividends payable).
    • Add increase in current liabilities (Accounts Payable, Accrued Liabilities, Tax Payable etc.)
    • Subtract decrease in Current Liabilities
    The result is ‘Net Cash Flow from Operating Activities’

Note:
A healthy business should generate positive net cash flow from operating activities and should grow the amount over time. If a business fails to consistently generate positive net cash from operating activities, it may need to rely on outside financing to operate, which will not sustain a business long term.

 

Investing activities

Steps for calculating cash flow from investments using Direct/Indirect method:

  • Add back losses (Cash spent)
    • Purchase of Fixed Assets
    • Purchase of investment instruments (Stocks & Bonds) of other companies
    • Lending money
  • Subtract out gains (Cash earned)
    • Sale of Fixed Assets
    • Sale of investment instruments
    • Insurance settlements on damaged Fixed Assets
    • Cash receipt from payback of loan

Note:
A stable or growing business typically has negative net cash flow from investment activities, which occurs when it buys more assets than it sells. A growing business routinely invests in new assets to expand its capacity, replace old equipment and to keep up with new technology.

Financing Activities

Steps for calculating cash flow from financing activities using Direct/Indirect method:

  • Add cash inflows
    • Sale of stock / issuance of new equity shares
    • Issuance of debt, such as bonds and debentures
    • Donor contributions restricted to long-term use
    • Proceeds from borrowings from banks or other financial institutions.
  • Subtract cash outflows
    • Repurchase of company stock
    • Repayment of debt/borrowings/loans
    • Payment of dividends

Note:
A healthy business may occasionally show positive net cash flow from financing activities as it raises money from investors and creditors to grow its business, but a healthy business should more often show negative net cash flow from financing activities. A negative amount suggests the business is using its cash flow from operating activities to pay dividends and pay off its outside financing.

 

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