The Finmark Blog is here to educate founders on key financial metrics, startup best practices, and everything else to give you the confidence to drive your business forward. The indirect method comes with a number of advantages, which makes sense given its popularity. The indirect method tends to be more popular given how much easier it is to create than the direct method, but there are some potential drawbacks to this approach that are important to keep in mind.

The data set explained
these net book value and cash proceeds facts for Propensity
Company. Increases in net cash flow from investing usually arise from the sale of long-term indirect method assets. The cash impact is the cash proceeds received from the transaction, which is not the same amount as the gain or loss that is reported on the income statement.

Explaining Changes in Cash Balance

Earlier we discussed how the cash from operating activities can use either the direct or indirect method. Most companies report using the indirect method, although some will use the direct method (see CVS’s 2022 annual report here). On the other hand, you should add any increase in your current liability accounts and subtract any decreases. You’ll likely already have this financial statement completed, so simply refer back to the figure that you’ve already calculated.

Although the FASB recommends preparing statements using the direct method, over 90% of companies use the indirect form of reporting. All of these adjustments are totaled to adjust the net income for the period to match the cash provided by operating activities. The non-cash expenses and losses must be added back in and the gains must be subtracted.

How to Build a Statement of Cash Flows in a Financial Model

The payable arises, or increases, when an expense is recorded but the balance due is not paid at that time. An increase in salaries payable therefore reflects the fact that salaries expenses on the income statement are greater than the cash outgo relating to that expense. This means that net cash flow from operating is greater than the reported net income, regarding this cost. This rise in the receivable balance shows that less money was collected than the sales made during the period. Thus, the $19,000 should be subtracted in arriving at the cash flow amount generated by operating activities.

This method doesn’t show the individual transactions that are driving cash inflows or outflows. So, it can be difficult for finance managers to pinpoint exactly what’s dragging down their operating cash flow, or conversely, what’s supporting it. The indirect method for building cash flow statements lacks some of the granularity that business leaders may be looking for.

Prepare the Investing and Financing Activities Sections of the Statement of Cash Flows

When cash is paid to a supplier for purchases previously made on account, cash decreases. Thus, a decrease in the accounts payable balance represents a decrease in cash and the $919 decrease is subtracted from net income. Gains and/or losses on the disposal of long-term assets are
included in the calculation of net income, but cash obtained from
disposing of long-term assets is a cash flow from an investing
activity. Because the disposition gain or loss is not related to
normal operations, the adjustment needed to arrive at cash flow
from operating activities is a reversal of any gains or losses that
are included in the net income total. A gain is subtracted from net
income and a loss is added to net income to reconcile to cash from
operating activities.

This amount will be reported in the balance sheet statement under the current assets section. This is the final piece of the puzzle when linking the three financial statements. When preparing an indirect method cash flow statement, you’ll start with the net income reported on the income statement.

To
reconcile net income to cash flow from operating activities,
subtract decreases in current
liabilities. Decreases in current liabilities indicate a decrease in cash relating to (1) accrued expenses, or (2) deferred revenues. In the first instance, cash would have been expended to accomplish a decrease in liabilities arising from accrued expenses, yet these cash payments would not be reflected in the net income on the income statement. In the second instance, a decrease in deferred revenue means that some revenue would have been reported on the income statement that was collected in a previous period.