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

Preparing a Statement of Cash Flows Using the Indirect Method

Business people a cash flow statement
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The statement of cash flows provides valuable information about a company's gross payments and receipts and allows insights into its future income needs.  The cash flows statement is comprised of three sections: operating activities, investing activities, and financing activities.  There are two methods for preparing a statement of cash flows: the direct method preferred by the Financial Accounting Standards Board (FASB) and the indirect method preferred by most businesses for its simplicity.  The difference between the two methods lies in the operating activities section of the statement.

  The direct method lists cash receipts from operations and cash disbursements related to the operations that consumed cash.  The indirect method begins with the net income from the income statement, which is then adjusted for noncash items, such as depreciation.

Data Needed to Prepare a Statement of Cash Flows 

To prepare a statement of cash flows, you must refer to the comparative balance sheets for XYZ company. From the two years of balance sheet data and some income statement data, you build your cash flows statement.

Statement of Cash Flows Example

In the following example, we will assume that net income is $110,500, depreciation is $50,000, and the firm pays out dividends in the amount of $65,000.

XYZ Company Statement of Cash Flows Example

XYZ Company Statement of Cash Flows
1. Net Income $ 110,500
2. Depreciation 50,000
3. Inc in Accts Rec (30,000)
4. Inc in Inventory (20,000)
5. Dec in Prepaid Exp 10,000
6. Inc in Accts Payable 35,000
7. Dec in Accruals (5,000)
8. Net Cash Flows from operating activities $150,500
9. Inc in Investments (30,000
10. Inc in Plant & Equipment (100,000)
11. Net Cash Flows from investing activities (130,000)
12. Inc in LT Bank Loans 50,000
13. Dividends Paid (65,000)
14. Net Cash Flows from financing activities (15,000)
15. Net increase in cash flows $5,500

Section One: Cash Flows From Operations

The first section of the statement is Cash Flows from Operating Activities. Line 1 is Net Income. To net income, add depreciation (line 2). After taking net income and depreciation into account, you then consider any increases or decreases in your current asset and current liability accounts between the two years of balance sheet information provided by the comparative balance sheets.

Looking at the balance sheets, accounts receivable (line 3) has increased by $30,000 from $170,000 to $200,000. Since that increase occurred on the asset side of the balance sheet, it is shown as a negative figure. Why? If the firm extended $30,000 more in credit to its customers, then it had $30,000 less to use. Likewise, inventory (line 4) increased by $20,000. Prepaid expenses (line 5) decreased by $10,000. A decrease in an asset account, a source of funds to the firm, is a positive number. Cash increased by $35,000, but it is not included in our initial analysis.

It will soon become clear why.

Now, look at the liabilities section of the balance sheet.  Accounts payable (line 6) increased by $35,000. Short-term bank loans didn’t change. Accrued expenses (line 7), such as taxes and wages, decreased by $5,000. Since this is a decrease in a liability account - a use of funds to the firm -, it is a negative number.

Line 8 is Net Cash Flows from Operating Activities, the summary of the first section of the Statement of Cash Flows. When you add up the adjustments to net income and depreciation, you get $150,500. The firm is generating a positive net cash flow from its operating activities.

Cash Flow from Investing Activities

The next section of the Statement of Cash Flows is Cash Flows from Investing Activities. Usually, this section includes any long-term investments the firm makes plus any investment in fixed assets, such as plant and equipment. Line 9 shows that the firm invested $30,000 more in long-term investments. That shows up as a negative number as it was a use of assets. The firm also spent $100,000 for more plant and equipment (line 10).

Line 11 is Net Cash Flows from Investing Activities, the summary of the second section of the Statement of Cash Flows. The total of this section is -$130,000 since this was an outlay of cash.

Cash Flow from Financing Activities

The last section of the cash flow statement is Cash Flows from Financing Activities. In this case, you have financed your firm with long-term bank loans that have increased by $50,000 as indicated on Line 12. Dividends to investors in the amount of $65,000 have also been paid, which is a cash outflow and a negative number as stated on line 13. Net Cash Flows from Financing Activities (line 14) is a negative $15,000.

Net Cash Flow: the Bottom Line

Now, we combine the three sections of the cash flow statement to see where the firm is from a cash flow perspective. When you sum the net cash flow from each section (line 15), you get a positive $5,500. This is the net increase in cash flows over the year for the business firm. Looking back at the cash account on the comparative balance sheets, the analysis is correct. Cash has increased by $5,500 from year to year.