The indirect method is a way to prepare the operating section of the statement of cash flows. It starts with net income (an accrual-basis amount) and then makes adjustments for noncash items, nonoperating gains and losses, and changes in balance-sheet accounts to convert net income into cash flows from operating activities (Investopedia).
Why it matters
– Investors and creditors focus on actual cash generated or used by operations. The indirect method translates accrual accounting results into cash terms.
– It’s the most commonly used method because it can be prepared directly from the income statement and comparative balance sheets (Investopedia; University of Minnesota).
Key concepts
– Net income: Profit after all revenues and expenses, including noncash items such as depreciation and amortization (CFI Education).
– Operating activities: Core revenue-producing activities and related inflows/outflows (receipts from customers, payments to suppliers and employees, taxes, interest, etc.) (AccountingTools).
– Rule of thumb for working capital adjustments:
• Increase in a current asset → subtract from net income.
• Decrease in a current asset → add to net income.
• Increase in a current liability → add to net income.
• Decrease in a current liability → subtract from net income.
Step-by-step: How to prepare cash flow from operating activities using the indirect method
1. Gather documents
• Latest income statement (profit & loss) and the current and prior period balance sheets (Investopedia; Harvard Business School Online).
2. Start with net income (first line).
3. Remove noncash expenses (add back): depreciation, amortization, stock-based compensation, impairment charges, bad-debt expense. These reduced net income but did not use cash.
4. Remove nonoperating gains and losses: subtract gains on asset sales; add losses on asset sales. (Proceeds from sales go in investing activities; the gain/loss is an accounting adjustment.)
5. Adjust for changes in operating working capital (compare current vs prior period balances):
• Accounts receivable: increase → subtract; decrease → add.
• Inventory: increase → subtract; decrease → add.
• Prepaid expenses: increase → subtract; decrease → add.
• Accounts payable, accrued expenses, deferred revenue: increase → add; decrease → subtract.
6. Add/subtract any other reconciling items: deferred taxes, provisions, noncash interest expense, unrealized gains/losses, etc.
7. Sum to get cash provided by (or used in) operating activities.
8. Verify arithmetic and reconcile to change in cash when combined with investing and financing cash flows.
Worked example (practical)
Assume a company with these items for the period:
– Net income: $120,000
– Depreciation expense: $20,000 (noncash)
– Gain on sale of equipment: $8,000 (nonoperating)
– Accounts receivable increased by $15,000 (current asset)
– Inventory decreased by $5,000
– Accounts payable increased by $10,000
Indirect-method adjustments:
– Start with net income: 120,000
– Add back depreciation: +20,000 → 140,000
– Subtract gain on sale of equipment: −8,000 → 132,000
– Subtract increase in Accounts Receivable: −15,000 → 117,000
– Add decrease in Inventory: +5,000 → 122,000
– Add increase in Accounts Payable: +10,000 → 132,000
Result: Cash provided by operating activities = $132,000
Why each adjustment is made (brief)
– Depreciation lowered net income but did not consume cash → added back.
– Gain on sale increased net income without cash operating effect → removed (the cash from the sale is shown under investing activities).
– Increase in A/R indicates sales were booked but cash not collected → reduce operating cash.
– Decrease in inventory suggests less cash tied up in inventory → increase operating cash.
– Increase in A/P means the company delayed payments to suppliers → increases cash retained this period.
Indirect vs direct method (summary)
– Indirect: Starts with net income and reconciles to cash by adjustments. Easier to prepare from standard financials and widely used.
– Direct: Lists actual cash receipts and cash payments (cash collections from customers, cash paid to suppliers/employees, etc.). More transparent about specific cash flows but often more time-consuming to assemble (Investopedia; Harvard Business School Online).
– Both produce the same net cash from operating activities; they differ in presentation.
FASB preference and disclosure
– The Financial Accounting Standards Board (FASB) prefers the direct method because it shows cash receipts and payments explicitly; however, most companies use the indirect method in practice. If the direct method is used, companies are still typically expected to provide reconciliation details (Investopedia).
Common reconciling items and examples
– Noncash expenses: depreciation, amortization, stock-based compensation, impairment.
– Accruals and deferrals: deferred taxes, allowance for doubtful accounts.
– Gains/losses on asset sales: remove gain (or add loss).
– Changes in working capital: accounts receivable, inventory, prepaid expenses, accounts payable, accrued liabilities, deferred revenue.
Practical checklist before finalizing
– Use comparative balance sheets (current and prior period) for working capital changes.
– Confirm classification of items: interest and dividends—classification can differ (under US GAAP interest paid/received typically operating; under IFRS interest received may be investing). Check applicable accounting guidance.
– Reconcile the net change in cash (operating + investing + financing) to the change in cash on the balance sheet.
– Disclose significant noncash investing/financing activities separately (e.g., asset acquired via finance lease).
– Be consistent period-to-period for comparability.
Advantages and disadvantages
– Advantages of indirect method: simpler to prepare from income statement and balance sheets; highlights link between net income and cash flows; preferred by many practitioners for efficiency.
– Disadvantages: less detail about specific cash receipts/payments than the direct method; may be less intuitive to some users (Investopedia; The CPA Journal).
Common mistakes to avoid
– Forgetting to reverse noncash items (e.g., not adding back depreciation).
– Mis-signing working capital changes (remember the rules about increases vs decreases).
– Including investing/financing cash flows in the operating section.
– Omitting noncash financing or investing disclosures.
Bottom line
The indirect method produces the same net cash from operating activities as the direct method, but by starting with net income and applying adjustments for noncash items and balance-sheet movements. It’s widely used because it’s efficient and follows naturally from standard accrual accounting records. For transparency, however, standards setters often favor the direct method; either way, accurate reconciliation and disclosure are essential (Investopedia; Harvard Business School Online).
Sources and further reading
– Investopedia, “Indirect Method” (user-provided).
– Harvard Business School Online, “How to Prepare a Cash Flow Statement.”
– University of Minnesota Twin Cities, “Cash Flows from Operating Activities: The Indirect Method.”
– CFI Education, “Net Income.”
– AccountingTools, “Operating Activities Definition.”
– The CPA Journal, “The Statement of Cash Flows Turns 30.”
– Produce a formatted one-period cash-flow-from-operations schedule using your numbers; or
– Convert a hypothetical company’s full set of financial statements into a complete statement of cash flows (indirect) and reconcile it to the balance-sheet cash change.