Question

Explain what the indirect method of reporting cash flow is. Provide an example.

Answer 1

The indirect method of reporting cash flow involves preparation of the cash-flow statements starting from the net income or profit after tax and then adjusting it with non-cash expenses from the income statement and changes in balance sheet items to arrive at the changes in the cash flow for a year.

Example (with explanation below):

		Source
Net Income (profit after tax)	3000	Income statement
Adjusted for
- Depreciation	125	Income statement
- Increase in accounts receiable	-200	Difference in two balance sheet items
- Decrease in inventories	300	Difference in two balance sheet items
Cash generated from operations	3225
Cash from investing activies	-5000
- Investment in an asset	-5000	Difference in two balance sheet items
Cash from financing activities	100
- Interest paid	-100	Income statement
- Loan repaid	-200	Difference in two balance sheet items
- New share issued	400	Difference in two balance sheet items
Total cash flow	-1675

1. Cash flow from operations: This tells you how much cash is being generated / burned in running the core operations of the business. For eg. if you are running a restaurant, how much cash have you earned in selling food and how much cash you have paid in buying ingredients like meat, oil, vegetables, fish etc. Keep in mind, this is actual cash paid or received. So if you have delivered food under credit scheme or you have procured raw-material under credit, those transactions will not show up until and unless you have actually paid the cash. Similar, any advance you might have received for food to be delivered or advance paid for ingredients to be procured will not be considered here. This is a very good indicator of how successful the core operations of the business are.

So from the income statement, you can get revenue from operation (let us call it R) and from the balance sheet you get accounts receivable (let us call it AR) as well as advance received for food to be delivered (let us call it AR1). However, keep in mind that an income statement provides a detail of what has happened during the year, while the balance sheet provides a stock of situation at a point in time. As a result, while generating the cash flows, you need to take the difference in the line items between two consecutive periods. I will call them DeltaAR (for difference in AR) and DeltaAR1 (for difference in AR1)

So cash income = CI = R – DeltaAR + DeltaAR1

From the same income statement, you can get expenses to procure ingredients (let us call it X) and from the balance sheet you get accounts payable (let us call it AP) and advance paid for ingredients (let us call it AP1).

So cash expense = CX = X – DeltaAP + DeltaAP1 (As explained above, the balance sheet items differences need to be taken).

Assuming no other income or expenses, Cash Flow from Operations (CFO) = CI - CX

2. Cash flow from financing: This tells you how much money is being spend in financing the operations of the business. For eg. If you have taken a loan for buying a new equipment for the restaurant, the principal received from the bank will be shown here in year when you took the loan (let us call this year 0). Then eventually you will be repaying the loan as well as repay the principal amount.

From the income statement, you get the following:

Interest paid – call it I

From the balance sheet, you will get the outstanding loan amount – call it OD. The difference in two years loan amount will provide you with the amount of principal repaid during the year.

So, cash flow from financing (CFF) = - I – DeltaOD (these are negative since you are paying these out).

If during a particular year you need to raise equity or pay dividends or buy back share, they will also show up under CFF. Any equity raised will be positive cash flow, while dividends paid or shares brought back will be negative cash flow.

3. Cash flow from investing: Any income you receive from long term investments will be here. These will involve interest income on any fixed deposits, your cash in bank, any new equipment you purchased, any new expansion or proceeds received from the sale of any equipment or asset. In the cash of the restaurant example, this could include cash paid towards acquiring any new shop, piece of land or equipment. This could also include proceeds received from selling of a shop, land or equipment.