- Calculate cash flows from operating activities by the indirect method
Let’s look at the indirect method first. Remember from our previous conversations, companies only use one method and typically they use the direct method! We just want to talk about the indirect method so you understand the concept!
The indirect method starts with your net income and adds or subtracts the items based on changes in their balances. Remember the operating activities that affect cash flow:
|Collect cash from your customers||X|
|Pay for inventory||X|
|Pay your bills! (utilities, rent, insurance)||X|
|Pay your employees||X|
|Pay interest on loans||X|
|Pay your taxes||X|
There are related accounts on the balance sheet, that when changes happen, we need to know how they affect the statement of cash flows:
|If the account balance increases||If the account balance decreases|
|Accounts Receivable (money from customers)||Subtract||Add|
|Inventory (buy or pay for inventory)||Subtract||Add|
|Prepaid expenses (insurance)||Subtract||Add|
|Accounts Payable (pay your bills)||Add||Subtract|
|Accrued Liabilities (payroll)||Add||Subtract|
|Income taxes payable (tax payments)||Add||Subtract|
This can be a really confusing concept, so let’s look at some examples.
- 1/1/20XX Accounts Receivable Balance $5000
- 1/31/20XX Accounts Receivable Balance $4000
The account balance decreased, so we need to add $1000 to our cash for the month because we received that much more in cash from our customers.
Let’s look at another one!
- 1/1/20XX Accounts Payable Balance $8000
- 1/31/20XX Accounts Payable Balance $5000
The account balance decreased so we need to subtract $3000 from our cash for the month because we paid down our accounts payable balance?
Hopefully this is making more sense! If you are working on a cash flow statement, you can keep the little chart with you!
- The Indirect Method. Authored by: Freedom Learning Group. Provided by: Lumen Learning. License: CC BY: Attribution