Which of the following best describes the indirect method of preparing the operating activities section of the statement of cash flows?

Cash flow statements are one of the three fundamental financial statements financial leaders use. Along with income statements and balance sheets, cash flow statements provide crucial financial data that informs organizational decision-making. While all three are important to the assessment of a company’s finances, some business leaders might argue cash flow statements are the most important.

Business owners, managers, and company stakeholders use cash flow statements to better understand their companies’ value and overall health and guide financial decision-making. Regardless of your position, learning how to create and interpret financial statements can empower you to understand your company’s inner workings and contribute to its future success.

Related: The Beginner's Guide to Reading & Understanding Financial Statements

Here’s a look at what a cash flow statement is and how to create one.

What Is a Cash Flow Statement?

A cash flow statement is a financial report that details how cash entered and left a business during a reporting period.

According to the online course Financial Accounting: “The purpose of the statement of cash flows is to provide a more detailed picture of what happened to a business’s cash during an accounting period.”

Related: How to Read & Understand a Cash Flow Statement

Since cash flow statements provide insight into different areas a business used or received cash during a specific period, they’re important financial statements when it comes to valuing a company and understanding how it operates.

A typical cash flow statement comprises three sections: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.

How to Create a Cash Flow Statement

1. Determine the Starting Balance

The first step in preparing a cash flow statement is determining the starting balance of cash and cash equivalents at the beginning of the reporting period. This value can be found on the income statement of the same accounting period.

The starting cash balance is necessary when leveraging the indirect method of calculating cash flow from operating activities. However, the direct method doesn’t require this information.

2. Calculate Cash Flow from Operating Activities

One you have your starting balance, you need to calculate cash flow from operating activities. This step is crucial because it reveals how much cash a company generated from its operations.

Cash flow from operations are calculated using either the direct or indirect method.

Direct Method

The direct method of calculating cash flow from operating activities is a straightforward process that involves taking all the cash collections from operations and subtracting all the cash disbursements from operations. This approach lists all the transactions that resulted in cash paid or received during the reporting period.

Indirect Method

The indirect method of calculating cash flow from operating activities requires you to start with net income from the income statement (see step one above) and make adjustments to “undo” the impact of the accruals made during the reporting period. Some of the most common and consistent adjustments include depreciation and amortization.

Related: Financial Terminology: 20 Financial Terms to Know

Both the direct and indirect methods will result in the same number, but the process of calculating cash flow from operations differs.

While the direct method is easier to understand, it’s more time-consuming because it requires accounting for every transaction that took place during the reporting period. Most companies prefer the indirect method because it's faster and closely linked to the balance sheet. However, both methods are accepted by Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

Related: GAAP vs. IFRS: What Are the Key Differences and Which Should You Use?

3. Calculate Cash Flow from Investing Activities

After calculating cash flows from operating activities, you need to calculate cash flows from investing activities. This section of the cash flow statement details cash flows related to the buying and selling of long-term assets like property, facilities, and equipment. Keep in mind that this section only includes investing activities involving free cash, not debt.

4. Calculate Cash Flow from Financing Activity

The third section of the cash flow statement examines cash inflows and outflows related to financing activities. This includes cash flows from both debt and equity financing—cash flows associated with raising cash and paying back debts to investors and creditors.

When using GAAP, this section also includes dividends paid, which may be included in the operating section when using IFRS standards. Interest paid is included in the operating section under GAAP, but sometimes in the financing section under IFRS as well.

5. Determine the Ending Balance

Once cash flows generated from the three main types of business activities are accounted for, you can determine the ending balance of cash and cash equivalents at the close of the reporting period.

The change in net cash for the period is equal to the sum of cash flows from operating, investing, and financing activities. This value shows the total amount of cash a company gained or lost during the reporting period. A positive net cash flow indicates a company had more cash flowing into it than out of it, while a negative net cash flow indicates it spent more than it earned.

Cash Flow Statement Example

To help visualize each section of the cash flow statement, here’s an example of a fictional company generated using the indirect method.

Go to the alternative version.

This cash flow statement is for a reporting period that ended on Sept. 28, 2019. As you'll notice at the top of the statement, the opening balance of cash and cash equivalents was approximately $10.7 billion.

During the reporting period, operating activities generated a total of $53.7 billion. The investing activities section shows the business used a total of $33.8 billion in transactions related to investments. The financing activities section shows a total of $16.3 billion was spent on activities related to debt and equity financing.

At the bottom of the cash flow statement, the three sections are summed to total a $3.5 billion increase in cash and cash equivalents over the course of the reporting period. Therefore, the final balance of cash and cash equivalents at the end of the year equals $14.3 billion.

Financial Decision-Making

Whether you’re a manager, entrepreneur, or individual contributor, understanding how to create and leverage financial statements is essential for making sound business decisions.

The statement of cash flows is one of the most important financial reports to understand because it provides detailed insights into how a company spends and makes its cash. By learning how to create and analyze cash flow statements, you can make better, more informed decisions, regardless of your position.

Are you interested in gaining a toolkit for making smarter financial decisions and the confidence to clearly communicate them to key stakeholders? Explore Financial Accounting—one of three courses comprising our Credential of Readiness (CORe) program—to discover how you can unlock critical insights into your organization’s performance and potential.

Data Tables

Company A - Statement of Cash Flows (Alternative Version)

Year Ended September 28, 2019 (In millions)

Cash and cash equivalents, beginning of the year: $10,746

OPERATING ACTIVITIES

INVESTING ACTIVITIES

FINANCING ACTIVITIES

Increase / Decrease in Cash and Cash Equivalents: 3,513

Cash and Cash Equivalents, End of Year: $14,259

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