On the statement of cash flows under operating activities you have the “changes in receivables”, “changes in inventory” etc. When you see those lines, you know the cash flows are presented using the indirect method. The direct method is always used for investing and financing activities, but can be used for operating as well. However, as the direct method is fairly simple, with this post we are going to explain the logic behind the indirect method.

First and foremost, the “changes in” are disclosed for those areas which are directly connected to operations – receivables, inventory and payables. They are those balances, which are affected by revenue, cost of goods sold, operating expenses etc.

In essence, they act sort of similar to those “paid” and “received” amounts on the statement. For them you start from the brought forward balance, add expenses or income and subtract the carried forward balance. What the changes are, are in essence the difference between the brought forward and carried forward balance. If you add to this the operating profit it all starts from (sum of incomes and expenses) you reach the same result as you would with the direct cash movements. The formula in a way is the same – you have the brought forward, the income or expense from the income statement and the carried forward balance – just the presentation is different.

Considering the above you basically reach to the one result – net inflow or outflow from operating activities. Kind of like if you paid yourself for the operations or were you paid.

Interest paid on the statement of cash flows can be disclosed either under operating or financing activities. No doubt you have seen both being used and it would make sense to have them either under one or the other. None of these is wrong actually and we will explain why.

Operating activities and cash flows from operating activities are in essence those that keep the business going and relate to the everyday proceeds and expenses. They are your payables to suppliers, invoices for goods, sales, receivables from customers etc. What operating also means, is keeping the company liquid enough to have enough resources to keep everyday business going. As it happens, every business has taken some sort of operational loan – either overdraft or short term business loan to finance working assets. When you look at the loan like that – it’s taken to keep the operations going – it only makes sense to have those related interest disclosed under the activities the cash flow relates to.

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The word “cash flows” indicates to the key question you should be asking when preparing the statement. “Was cash actually paid?” is the number one question that should always be asked.

For an example in a situation where you have bought PPE items during the period and now are going to disclose the outflows on the cash flow statement. Ask yourself though if there aren’t any invoices still unpaid for those items. This is something we have seen in practice happening quite a lot. If there are invoices still unpaid to suppliers, those are already a part of the changes in accounts payable and should always be excluded from outflows amounts done to purchase the items disclosed on the statement. The reason behind this is obviously a simple fact that the cash didn’t move.

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On the statement of cash flows there are certain disclosed amounts which are all connected as they relate to the same area. When preparing the statement, you can easily check yourself by just adding all those connected amounts and compare it with the change on the balance sheet. If it all equals, you can be sure that you have included and disclosed all information.

For an example, a very easy check is the PPE items on the statement under all sections. You include the acquisitions, take off the depreciation and the difference between the proceeds and loss / gain made from the sale to reach a change in carrying value of PPE on the balance sheet. Basically what you do is add sales, take off depreciation as it decreases the carrying value and also take off the carrying value of sold and disposed goods as this also decreases the carrying value. The result should equal to the change on the balance sheet.

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You are positive that you included everything possible and needed, did the check to make sure all one off deals are disclosed, made sure that actual cash moved in the amounts stated and still end up with a difference.

In case the difference is small, the easiest way and less stressful then trying to find where it arises, is simply adding it to some line, which cannot be easily matched with something from the main statements and notes. The differences, in case you are sure about all other numbers, can easily be a part of something vague, like fixed assets acquisition – there may easily be invoices still unpaid so the result doesn’t have to match with the acquisitions disclosed in relevant notes anyway.

Also a good thought here is to make sure you add it into a group from which it makes say less than 10%. You wouldn’t want the difference added to affect the line value considerably.

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When preparing statement of cash flows there are things that you always come across – change in inventories, payables and receivables, payment and receiving of loans and fixed assets depreciation, acquisitions etc. These are the first things that are usually entered into the statement and rarely forgotten. You simply have most dealings with those balances daily and as such, you are more used to noticing when they are missing.

After you have entered into the statement all the possible cash flows you know and regardless of its adding up with the actual change in the cash balances or not, think at least once and thoroughly – did you get everything? Are all the transactions and cash flows reflected on the statement?

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Interest received, Repayments of loans granted, Repayments of loans received etc. – how are they reached? Considering that the period for which the statement is prepared is long and the company has various transactions going through its bank account, manually picking interest received may not be an option. But how should you do it then?

The logic is fairly simple and is similar to the one we already explained in the post How to reach those “paid” amounts on the statement of cash flows? Your beginning or brought forward balance is something you would expect to have received during the current period. In addition, you have current period income, which you’d again expect that part is already received during the period. So you simply add them up. To bring you an example:

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On the statement of cash flows there are line items including “paid” within them. Considering that the period for which the statement is prepared for is long and your company does various transactions over the year, picking out for an example all interest payments from the bank account abstract isn’t really efficient. But then how do you reach to for an example “paid interest” amount?

The logic is fairly simple when you think about it. Your beginning or brought forward balance is something you would expect to pay during the current period. In addition, you have current period expense as well, from which you’d again expect that part is already paid during the period. So you simply add them up. To bring you an example:

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The statement of cash flows could always be just a list of various cash flow items all randomly one after each other. However, it wouldn’t be of much use that way. Hence, as a business in involved in 3 types of activities – operating its business, investing into assets and financing its activities –, those are the groups also the cash flows are presented for.

Now to give a little bit more insight to those 3 groups let’s start with operating cash flows. Those are the cash flows generated through normal course of business – selling, buying and producing. What sometimes is also included within this group, are the interest paid. It’s simply because financing is usually received for keeping or supporting main operations so it’s more suitable to have them as a part of operating activities. However, note that the financing itself, i.e. loans, are never part of operating.

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The statement of cash flows is something that simply put reflects company’s net flows of cash. If negative, the company is spending more than it earns from operations or gets through financing and if positive, company has generated more cash than it has managed to spend on its activities and investing.

The statement itself is all about actual cash movement – the number one and key question at all times when preparing cash flows is did the cash actually move? It’s often forgotten and the amounts shown don’t always reflect the real cash movement. Always follow the money!

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