The indirect cash flow method is a technique used in accounting to determine the cash flow of a company. This method starts with the net income of a company and then adds or subtracts non-cash items to reconcile to actual cash flows from operations (Investopedia, 2023). This method is commonly used in practice, especially among larger firms (Tuovila, 2022).
Key Facts
- Calculation: The indirect method starts with net income on an accrual basis and then adds or subtracts non-cash items to reconcile to actual cash flows from operations.
- Purpose: The indirect method helps to present the sources and uses of cash by a company, showing the effects of changes in asset and liability accounts on its cash position.
- Non-cash items: Non-cash items are transactions that do not involve the exchange of cash, such as depreciation, amortization, changes in accounts receivable, and changes in accounts payable.
- Format: The indirect method presents the statement of cash flows beginning with net income or loss, followed by adjustments for non-cash revenue and expense items, resulting in cash flow from operating activities.
- Comparison with direct method: The indirect method is more commonly used than the direct method, which lists actual cash inflows and outflows. The indirect method is preferred because it is simpler to prepare and most companies already use accrual accounting.
Calculation of Indirect Cash Flow
The indirect cash flow method begins with the net income on an accrual basis. Non-cash items are then added or subtracted to reconcile to actual cash flows from operations. Non-cash items are transactions that do not involve the exchange of cash, such as depreciation, amortization, changes in accounts receivable, and changes in accounts payable (Investopedia, 2023).
Purpose of the Indirect Cash Flow Method
The indirect cash flow method helps to present the sources and uses of cash by a company. It shows the effects of changes in asset and liability accounts on a company’s cash position (Tuovila, 2022). This information is useful for investors, creditors, and other stakeholders to assess a company’s financial health and performance.
Format of the Indirect Cash Flow Method
The indirect method presents the statement of cash flows beginning with net income or loss. Adjustments for non-cash revenue and expense items are then made, resulting in cash flow from operating activities (Investopedia, 2023). The statement of cash flows is divided into three categories: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.
Comparison with the Direct Method
The indirect method is more commonly used than the direct method, which lists actual cash inflows and outflows. The indirect method is preferred because it is simpler to prepare and most companies already use accrual accounting (Tuovila, 2022). However, the Financial Accounting Standards Board (FASB) prefers companies to use the direct method as it offers a clearer picture of cash flows in and out of a business.
Conclusion
The indirect cash flow method is a valuable tool for understanding a company’s cash flow. It provides information on the sources and uses of cash, as well as the effects of changes in asset and liability accounts on a company’s cash position. This information is useful for investors, creditors, and other stakeholders to assess a company’s financial health and performance.
References
Investopedia. (2023). Cash Flow Statement: What It Is and Examples. Retrieved from https://www.investopedia.com/investing/what-is-a-cash-flow-statement/
Investopedia. (2022). How To Use the Indirect Method To Prepare a Cash Flow Statement. Retrieved from https://www.investopedia.com/terms/i/indirect_method.asp
Shopify. (2023). How To Use the Indirect Method for Cash Flow Statements. Retrieved from https://www.shopify.com/blog/cash-flow-statement-indirect-method
Tuovila, A. (2022). How To Use the Indirect Method To Prepare a Cash Flow Statement. Investopedia. Retrieved from https://www.investopedia.com/terms/i/indirect_method.asp
FAQs
What is the indirect cash flow method?
The indirect cash flow method is a technique used in accounting to determine the cash flow of a company by starting with the net income and then adding or subtracting non-cash items to reconcile to actual cash flows from operations.
Why is the indirect cash flow method commonly used?
The indirect cash flow method is commonly used because it is simpler to prepare and most companies already use accrual accounting.
What are non-cash items in the indirect cash flow method?
Non-cash items in the indirect cash flow method are transactions that do not involve the exchange of cash, such as depreciation, amortization, changes in accounts receivable, and changes in accounts payable.
How does the indirect cash flow method differ from the direct cash flow method?
The indirect cash flow method starts with net income and adjusts for non-cash items, while the direct cash flow method lists actual cash inflows and outflows.
What are the advantages of using the indirect cash flow method?
The advantages of using the indirect cash flow method include its simplicity and the fact that it is more commonly used, making it easier to compare companies.
What are the disadvantages of using the indirect cash flow method?
The disadvantages of using the indirect cash flow method include the fact that it can be difficult to understand and that it may not provide as much information as the direct cash flow method.
Which method is preferred by the Financial Accounting Standards Board (FASB)?
The FASB prefers companies to use the direct cash flow method as it offers a clearer picture of cash flows in and out of a business.
What are some examples of non-cash items that are added or subtracted in the indirect cash flow method?
Examples of non-cash items that are added or subtracted in the indirect cash flow method include depreciation, amortization, changes in accounts receivable, and changes in accounts payable.