How to Prepare a Statement of Cash Flows Using the Indirect Method

The statement of cash flows is one of three financial statements that a business has to prepare at the end of each accounting period. The other two financial statements are the income statement and balance sheet. These financial statements are used as internal documents to direct the firm's operations. They are also used as reporting documents for the firm's investors, creditors, members of the board of directors, and government agencies.

The statement of cash flows is comprised of three sections: cash from operating activities, cash from investing activities, and cash from financing activities. 

What is the Indirect Method for Preparing a Statement of Cash Flows?

The indirect method of preparing a statement of cash flows is a technique that begins with the net profit from the income statement, which is then adjusted for non-cash items such as depreciation. The indirect method is based on accrual accounting and is generally the best technique since most businesses use accrual accounting in their bookkeeping.

The direct method for preparing a statement of cash flows lists cash inflows and outflows as they occur. It is based on cash accounting. The Financial Accounting Standards Board (FASB) prefers that businesses use the direct method to develop the statement of cash flows. Since most firms use accrual accounting, they typically use the indirect method.

The Relationship Between the Balance Sheet and Statement of Cash Flows

The cash account on the balance sheet should reflect the total cash available to the firm as calculated on the statement of cash flows. The following five items may cause a difference between the balance sheet's cash account and the statement of cash flows and adjustments must be made. These items should be reflected in the statement of cash flows:

1. Net income before preferred dividends: Net income, from the income statement, usually means more cash in the bank. If a business has issued preferred stock, then net income is lower due to the necessity of paying dividends.
2. Non-cash adjustments to net income: In order to calculate cash flow, add back any non-cash expenses like depreciation and amortization.
3. Changes in working capital: Working capital is the current assets of the business. Increases in current assets (other than cash) decrease cash and decreases in current assets increase cash. Also, increases in current liabilities increase the cash account, and decreases in current liabilities decrease cash. Reflect these changes in the statement of cash flows.
4. Investments: If a business invests in fixed assets or short-term financial investments, then the cash account is decreased. If it sells fixed assets or short-term financial investments, cash is increased. These changes should be reflected in the statement of cash flows.
5. Securities transactions and dividends: If a business issues common stock or bonds, that should be reflected in the statement of cash flows as an increase in the cash account. If it, instead, buys back its stock or pays off debt, that is a decrease in the cash account. If the business pays dividends to common stockholders, cash is reduced.

The proper format of the statement of cash flows is to divide the changes in cash flow into three sections:

Cash Flows From Operations

The first section of the statement of cash flows deals with the company's changes in working capital. Changes in working capital are subtracted out/added to the firm's net income as indicated in Item 2 above.

Depreciation is a planned reduction in the value of a fixed asset as it is used. For the purpose of cash flows from operations, add all of your assets' depreciation expenses together to arrive at total depreciation expenses. See the equation below:

Cash Flow from Investing Activities

This section is a summation of the changes to the fixed asset account or the current liabilities account, with the exception of accounts payable. It includes purchasing or selling fixed assets, such as a plant or equipment, and issuing or buying back common stock. The rules for how to record the changes are in Item 3 above.

Other activities include settlement collections, loaning money, and collecting on loans you have made. This section deals with investing activities, like purchasing shares of stock—not financing activities such as securing funding.

Cash Flow from Financing Activities

This section of the statement of cash flows shows the company's financing activities—not recorded in the investing activities section—that were a result of transactions for funding or return of the funds along with any payment of any dividends. Changes in this section of the statement of cash flows come from actions the business takes to finance its operations.

The sale of company stock for financing can be recorded in this section, along with repurchase of stock, dividend payment, debt repayments (as long as it is for a financing activity). Changes in short-term or long-term debt are also represented here. Any payment going out is a negative change, and any payments received are positive changes.

Cash Flow Statement Example

Once you have calculated the necessary elements, you can begin to build your statement of cash flows. For smaller businesses, you may not have any of the investment activities discussed previously. In this case, you would not need to enter any information.

The net increase or decrease in the company's cash account is the sum of these three sections.

Here is an example of a statement of cash flows. Each line item after Net Income and Depreciation represents a change from one time period to another: