What is added back to net income when starting to determine cash flows using the indirect method?

When you need to prepare a cash flow statement, there are two options – direct method or indirect method. Both methods provide you with the same result, but their methodology differs in several significant ways. Check out our comprehensive guide to find out more about the cash flow statement indirect method and get a little more information about the direct method vs. indirect method of cash flow.

What is the indirect method of cash flow?

There are two ways to generate a cash flow statement: the direct method and the indirect method. The indirect method uses changes in your balance sheet accounts to calculate cash flow from operating activities. Put simply, any changes in asset and liability accounts that may affect your cash balances throughout the reporting period are added or subtracted from your net income at the beginning of the period, providing your operating cash flow. By contrast, the direct method lists all your business’s cash inflows and outflows during the reporting period, thereby allowing you to calculate your net cash flow from your business’s operating activities.

How to prepare a cash flow statement using the indirect method

It’s much easier to understand the indirect method of cash flow by looking at how to prepare a cash flow statement in depth:  

1. Set up the statement – When you’re calculating cash flow using the indirect method, you’ll start by recording the net income for a given period, before subtracting or adding non-cash expenses, losses, and gains. Non-cash expenses can include items like depreciation, amortization, and depletion.

2. Adjust your net income – Then, you’ll need to adjust your net income for changes in asset accounts that may have affected your company’s cash. Some of these accounts include inventory, prepaid expenses, and accounts receivable. At this point, you’ll need to calculate how these changes affect cash to work out which way your net income should be adjusted. For example, if an asset increases during the recording period, cash has left your business, so the increase needs to be subtracted from your net income.

3. Account for liabilities – Finally, you’ll need to adjust your net income for changes in your liability accounts. Some of the accounts that you’ll need to consider include accounts payable and accrued expenses. This step can be especially tricky, as liabilities have a credit balance, rather than a debit balance. In short, increases in liabilities must be added back into income, not subtracted. After you’ve made all these cash flow statement indirect method adjustments, you’ll have the total amount of cash from operating expenses. 

To see what the indirect method of cash flow looks like when you put all that information together, AccountingTools have produced an example of a statement generated using the indirect method, and there are many other examples and templates available online that you can explore at your leisure.

Cash flow statement indirect method format in Excel

There are a broad range of online tools that can help you produce a cash flow statement. For example, there are many different templates that include a cash flow statement indirect method format in Excel. After you’ve downloaded the template, all you need to do is enter your business’s financial information to calculate cash inflows and outflows according to the indirect method.

Direct method vs. indirect method of cash flow

When it comes to the direct method vs. indirect method of cash flow, you should remember that neither method is more effective than the other – they both provide the same result. Ultimately, it all comes down to personal preference. Many accountants prefer using the indirect method because it can be prepared relatively easily using information from your balance sheet and income statement. Having said that, the Financial Accounting Standards Board (FASB) favours the direct method, as it provides a clearer picture of the cash flows moving in and out of your business.

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Companies that use accrual basis accounting can assemble their statement of cash flows in one of two ways, using either the direct method or the indirect method. The more commonly used indirect method shows the company's net income, and adjusts it with reconciling entries, to arrive at the company's operating cash flow.

The less common direct method requires building a cash flow statement from the ground up, using data from potentially thousands of individual transactions, although it's often difficult to gather data in this manner. Conversely, the indirect method uses information from the company's income statement and balance sheet, making the cash flow statement preparation a simple exercise.

For the indirect method, start your reconciliation with your company's net income, or profit, for the desired time period. You'll find this figure at the bottom of the company's income statement. Unlike the cumulative nature of the income statement numbers, the balance sheet works like a snapshot, showing data at a certain point in time. For this reason, you'll need two balance sheets, such as two consecutive monthly versions, because it is the changes in the balance sheet accounts that represent the amounts that have been adjusted.

You'll need to make three types of adjustments to reach operating cash flow. The first, noncash items, includes items that don't reduce cash, but they still get recorded as an income statement expense that reduces net income. The second category, timing differences, involves changes in assets and liabilities on the balance sheet. These adjusting entries compensate for the way companies recognize revenue and expenses under accrual accounting rules. The third category covers non-operating gains or losses, which means income or losses generated by activities other than the core functions of the company.

In accrual accounting, some items change profits, but don't have any effect on cash flow. Reconciling net income to operating cash flow involves adding or subtracting these noncash items. To get started, enter all of the noncash expenses shown on the income statement during the given reporting period into your cash flow adjustment calculation. Depreciation and amortization are the most common examples, and these income statement expenses reduce net income but have no effect on cash flow, so they must be added back.

Opposite of the noncash items, certain current assets affect your company's actual cash flow but don't affect your income statement profit. They include inventory, accounts receivable and prepaid expenses. When a current asset increases, it reduces your operating cash flow in relation to net income. For example, if you have an item in inventory, that means you've laid out cash for it. But because of accrual accounting rules, if you haven't sold it yet, you can't report its cost as an expense, and therefore, its cost hasn't yet reduced net income.

This represents an accounting timing difference and needs to be factored into your reconciliation. For each category of current assets except cash, take the account balance from the balance sheet at the beginning of your given period and the same figure from the balance sheet at the end period. Subtract the beginning figure from the ending figure to get the period change for that particular current asset. Do this for all categories of current assets, and record these differences in your reconciliation calculation.

Current liabilities on the balance sheet include accounts payable and accrued expenses such as wages and rent. These accrued expenses have been incurred and reported, but the company has not yet paid out any cash. Current liabilities have the opposite effect on cash flow as that of current assets. When a current liability increases, such as accruing another week of wages owed, cash flow goes up, relative to net income.

For example, as workers earn wages, you report what they earn as an income statement expense, which reduces net income. But until you actually issue paychecks, their wages won't yet reduce cash flow. Calculate the period change in each category of current liabilities the same way you did for current assets, and add these results to your reconciliation.

If your company has any gains or losses coming from non-operating activities, you'll need to also factor these into your reconciliation. Look for gain or loss items on the income statement. Examples include charges related to discontinued operations, and any profit over book value from sales of non-inventory items, such as old equipment or office furniture. Take the appropriate figures from the income statement and add them to your reconciliation.

Start your reconciliation with net income at the top. Add back the total value of noncash expenses to your operating cash flow. Next, subtract the period change for each category of current assets. Then, add the period change in each category of current liabilities. Some of these period changes might be negative. Finally, add back any expenses related to non-operating activities, and subtract any income from non-operating activities.

Removing a negative charge increases your operating cash flow; adding a negative charge decreases your operating cash flow. Do the math to get to your reconciled cash flow from operations. If you add the two other sections of the cash flow statement, net cash flow from investment activities and net cash flow from financing activities, you'll have produced a complete cash flow statement.