The Indirect Method

Learning Outcomes

  • Calculate cash flows from operating activities by the indirect method

Let’s look at the indirect method first. 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:

Description Inflow Outflow
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, so 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
Current Assets
Accounts Receivable (money from customers) Subtract Add
Inventory (buy or pay for inventory) Subtract Add
Prepaid expenses (insurance) Subtract Add
Current Liabilities
Accounts Payable (pay your bills) Add Subtract
Accrued Liabilities (payroll) Add Subtract
Income taxes payable (tax payments) Add Subtract

This can be a 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 example:

  • 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.

If you are working on a cash flow statement, you can keep the little chart with you. Complete the practice question to check your understanding.

Practice Questions