The other option of presenting the cash flows on the statement of cash flows is using the ‘indirect’ method. However, as previously stated, it’s only allowed and applicable in case of displaying the cash flows from operating activities. The other cash flows, namely from financing and investing activities are presented using the ‘direct’ method and you’ll soon see why.

The ‘indirect’ method of showing the cash flows is in a nutshell changes in balances added to operating profit. The result on the income statement which is accrual based is adjusted to show cash based result. This is to put things in very short explanation.

The changes themselves can be both negative and positive mathematically, but how are they affecting the cash flows? If for an example, the receivables balances have increased compared to prior date, it means we have money held up somewhere, so a negative net cash flow has occurred over the period. On the contrary, if we have acquired fewer inventories over the period between the two dates than we have actually sold over the same period, this results in a decrease of the balance, hence giving us a positive cash flow. The same logic also applies to all operating activities related payables meaning that when the balance has increased, we have been holding more money to ourselves resulting in a positive cash flow.

Note that all those changes are called ‘Adjustments’. In essence, the adjustments are made to the operating profit to reach the actual cash generated from operating activities. So when the income statement where the operating profit is taken from is accrual accounting based, the indirect method links the cash to those results alongside clarifying the distinction. To accomplish this, what needs to be done, is first remove the effects of items that appear on the income statement but do not affect cash (for an example depreciation, amortization) and items that are disclosed under ‘investing activities’ like ‘proceeds from sale of assets’ as discussed earlier in our posts. And to this adjusted profit you add all the changes in operating activities related balances, like for an example ‘trade receivables, ‘inventories’ and ‘trade payables’.

If you ask me, the ‘indirect’ method enables you to more easily analyze the status of the company as it gives you an insight to balance sheet changes as well. You can see whether the negative net cash flows from operating activities result from huge amount of inventory acquired (displayed as positive change in inventory on the balance sheet) or from the top meaning negative operating profit.

If you want to learn more about statement of cash flows and how to reach indirect cash flows, please check out our Office ToDo UNI courses.