Imagine you started a small business. (Maybe you don’t have to imagine.) After a year of hard work, you want to take stock of your company’s financial performance. Money is coming through sales, but cash is also going out as equipment purchases and salary payments. How do you determine your cash position? How do you figure out how much cash is coming and going and what you’re left with?
One way is to use the indirect method of cash flow statements. With this method, you can determine precisely how much money you’ve spent and brought in, how much you should have on hand, and get a solid grasp of your business’s financial stability over a given period.
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What is a cash flow statement?
A cash flow statement is a financial statement summarizing cash and cash equivalents entering and leaving a company during an accounting period. It measures a company’s ability to pay debts and expenses—handy for short- and long-term planning and regulating operations.
How is cash flow measured?
Cash flow is measured by subtracting the incoming money from the outgoing money. In other words, it’s the difference between cash inflows and cash outflows. A cash flow statement typically includes three main components:
- Operating activities. Cash spent or received from core business operations, such as providing products or services.
- Investing activities. Cash spent or received from the purchase or sale of long-term assets and other investments not included in cash equivalents, i.e., securities, loans, and capital expenditures.
- Financing activities. Cash spent or received from funding mechanisms such as equity, dividends, and debt.
Your cash flow can be positive or negative, depending on how much you make and spend. When your flow is positive, you can use the excess cash on investments or financing or put it into your savings. If your cash flow is negative, you may have to look into potential investors or dip into your savings to balance your books.
What is the indirect method of a cash flow statement?
In general terms, the indirect method is a way to calculate cash flow using transactions to determine payments and expenses rather than cash on hand. The indirect method measures how much a company made or spent through various sources over a given period. It helps evaluate a business’s current or relative health and financial stability and whether or not it has money to spend on growth and other investments.
The indirect cash flow method calculates cash flow by adjusting net income with differences from noncash transactions. It starts with a business’s net income and then lists cash flows, both received and paid, for various activities (i.e., the three cash flow categories: operating, investing, and financing). These activities are then added or subtracted from the business’s net income to determine its final net cash increase or decrease over the specified period.
The indirect method uses accrual basis accounting in its calculations. With accrual accounting, revenue is recorded when it is earned rather than when it is received—i.e., when a sale takes place, not when the money reaches the bank account. If a landscaping company that charges $30 per hour bills a client for four hours of work, under the accrual method, it would record $120 in revenue before any money changed hands. This method allows the company to account for all cash and credit sales, providing a clearer picture of the business’s financial health.
Lack of transparency in the indirect method
Although the indirect method is easy to prepare, it lacks transparency. It can be hard to track down and tally what’s been paid and what hasn’t, meaning it doesn’t always accurately represent a business’s cash on hand. Moreover, because all cash flow statements are typically calculated over a quarter or fiscal year, they only provide a limited snapshot of a company’s financial health, making it challenging to draw longer-term conclusions.
Direct cash flow method vs. indirect cash flow method
The direct cash flow method includes all the inflows and outflows of cash from operating activities. Rather than accrual accounting, it uses cash basis accounting, which recognizes revenues when cash is received and expenses when they’re paid, providing a real-time look at cash inflows and outflows. The direct method then tallies these payments and expenses similarly to the indirect method to determine a business’s net cash flow.
The direct method is straightforward and transparent but can be more time-consuming, as it requires parsing which expenses and income have been paid and which haven’t—one reason many larger companies prefer the indirect method.
How to prepare a cash flow statement using the indirect method
Using the indirect method to prepare a cash flow statement might seem intimidating. Breaking the process down can help.
1. Obtain the relevant documentation
Gathering your company’s financial information is the critical first step. This includes the two other basic financial statements: the balance sheet, which shows assets and liabilities, and the income statement, which lists expenses and revenue.
2. List the net income from the financial statements
Pull your company’s net income from its income statement, and list it on the first line of the cash flow statement. This is also where you add adjustments for finances, like asset depreciation, which you can insert in parentheses.
3. List cash and noncash operating activities
List your company’s cash and non-cash expenses and income, line by line. These typically include items like accounts receivable, asset sales, or amortization.
4. List investing activities
List out, line by line, the cash generated or lost through purchasing or selling stocks, securities, or loans.
5. List financing activities
List out, line by line, the cash your company generated or lost through funding mechanisms such as equity, dividends, and debt.
6. Tabulate the total
Add cash and non-cash operating, investing, and financing activities. If the resulting sum is negative, subtract it from the initial net income figure. If it’s positive, add it to the net income figure.
7. List the final cash balance
The result of this subtraction or addition is your net cash flow. A positive number indicates your business is relatively healthy, bringing in more cash than it spent over the period in question. If your company has a negative cash flow, you may be spending beyond your means, which could be unsustainable over the long term.
Indirect method for cash flow statements FAQ
What is the difference between the indirect and direct cash flow methods?
The direct cash flow method uses cash basis accounting rather than accrual accounting, providing a detailed look at cash inflows and outflows when determining a business’s net cash flow. The direct method can be more time-consuming but gives an accurate and detailed summary of a business’s cash flow operations.
What are the limitations of the indirect method?
The indirect method uses accrual basis accounting in its calculations, which means that the company may not have the cash on hand in some cases.
Moreover, as cash flow statements are typically calculated over a quarter or a fiscal year, they only provide a snapshot of a company’s financial state during a limited-time window. It can be challenging to draw any long-term conclusions about viability from these without considering factors such as significant market trends or the company’s history.
How do you calculate operating cash flow?
Operating cash flow (OCF) is the cash made from the sales of goods and services minus the money a company spends on operating expenses. The formula for calculating operating cash flow is:
Operating cash flow = Total cash received for sales − Cash paid for operating expenses
Operating cash flow can be calculated using direct or indirect cash flow statement methods.