Operating Activities: Indirect Method - Online Tutor, Practice Problems & Exam Prep

The Indirect Method for calculating Operating Cash Flows (OCF) begins with net income from the income statement, adjusting for non-cash expenses like depreciation and gains or losses from asset sales. Increases in current assets indicate cash outflows, while increases in current liabilities suggest cash inflows. This method focuses solely on operating activities, distinct from investing and financing activities. Understanding these adjustments is crucial for accurate cash flow analysis, which is essential for effective financial management and decision-making in accounting.

Indirect Method Summary

Alright, now let's learn how to calculate our Operating Cash Flows using the Indirect Method. So there are two methods for calculating Operating Cash Flows. We've got the indirect method, and guess what, the direct method. Most companies use the indirect method, and most professors just focus on the indirect method. A lot of textbooks teach both of them, but sometimes professors will just overlook the direct method and focus specifically on the indirect method. So, double-check if you're going to need to know the direct method before you spend some time with it, but definitely, you're going to need to know the indirect method. So let's start with that one here.

The indirect method starts with net income and it indirectly gets us to operating cash flows. That's why it's called the indirect method. I want to make one note here: regardless of whether you're using the indirect or direct method, you're only calculating your operating cash flows. When you do investing activities and financing activities, well those are their own beast. Regardless of the indirect or direct method, they have nothing to do with those methods. They're going to always be calculated the same way, regardless of if you use the indirect or direct method. The financing and investing activities are separate.

So let's go through the steps that we're going to go through in the indirect method. We're going to start here with net income, and net income is found on the income statement. You guys are ready with that by now. And that's our bottom line there. And then we're going to adjust that net income, based on different factors to arrive at our operating cash flows.

The first thing we want to know is that in net income, there are things that are not cash that are affecting our net income number. So what we want to do is we want to get rid of those non-cash effects. The first non-cash effect is non-cash expenses. So the first thing we're going to do is we're going to get rid of the effect of non-cash expenses. So we're going to add those back. If you think about it, an expense reduces income, right? If we take an expense, well that's going to reduce our net income. So if we are going to have a non-cash expense, we want to get rid of that effect in net income because we are only focused on cash activities when we're talking about the cash flows.

The most common non-cash expense, can you think of what it is? We've talked about it before in this course. Our most common non-cash expense is depreciation expense. When we talk about depreciation or amortization, think about depreciation expense. We had some machinery or some building that we bought, right? And we bought it upfront. We paid a big cash amount upfront and then over its useful life, we depreciate it. But when we take that depreciation, it's not like we're paying out cash to depreciate the building. It just represents the wear and tear on the building, right?

It's not an actual cash outflow when we take depreciation expense. So we want to get rid of that effect because that depreciation expense had reduced our net income. We want to get rid of that effect. So we're going to add it back in, right? We're going to add back the depreciation expense as if it had never happened. Okay? So we're going to add that back because we're focused on cash flows, right?

The next non-cash activity in net income is gains and losses. So if you think about when we sell a plant asset, maybe we sell a piece of equipment. Well, there is a cash flow involved there. Right? We're going to receive some cash for selling it, but the gain or the loss on the sale is the difference between that cash flow and the book value. Right? That gain itself is not a cash amount. So that's going to be affecting our net income because gains and losses, they do go into our income statement and they do affect our net income, but they're not a cash amount. So we want to get rid of their effects.

Now, you have to think about each effect separately, right? A gain and a loss are going to be opposites here. So let's start here with gains. When you think about it, you're going to have to think about it in a logical order. So first, you're gonna think, okay, a gain had originally increased Net Income. Right? Gains increase our Net Income, but like I said, they're not a cash cash amount. So we need to get rid of their effect. So we remove the effect of the gain, we must reduce the net income amount by that gain, as if it had never happened. Okay? So remember, this is all focused on finding our operating cash flow. We start with net income, which should be a number close to our operating cash flow, and we're adjusting it for all of these different items that shouldn't, that wouldn't be a cash effect. So we would deal with gains in that way, and then next we have losses. Losses are gonna be the opposite. Losses decrease our net income, so to get rid of their effect we must increase our net income, right? We must remove the effect of the loss by increasing our net income by the amount of the loss. Okay? So we're going to see all of these things in an example and it'll make a lot more sense once we get there.

But this sheet is going to be very important when you're studying and you're doing your practice problems, to solve the operating cash flow. So there we go, we've gotten rid of the non-cash effects in net income. The next thing we need to do is we need to deal with our changes in our current assets, except for cash and our changes in current liabilities. So the idea here is if there's an increase in a current asset, let's say at the beginning of the year you had $100,000 in inventory and at the end of the year you have $120,000 in inventory. Well, how could we have increased our inventory? We had to pay cash, right?

And that's the best way I think about it. I always think about it like this: I always think about a current asset, I always relate it to inventory because that one makes the most sense in my head. Right? The only way we could have increased our inventory balance throughout the year, was to have paid out more cash to increase that inventory. So now, it's almost like some of our cash balance is tied up in our inventory during, during the year. So we have less cash on hand. Right? We've decreased our cash to increase our inventory.

And it's the opposite. What if we decreased our inventory? Well, that means we've loosened up some of our cash that was tied up in the warehouse. Well, now it's not tied up anymore. So we have more cash available. Okay? So this is important because we're going to be looking at our balance sheet from year to year and we're going to see the change in each current asset and each current liability. And that's going to be a part of our calculation of our operating cash flow. Okay? So that's going to be very important and it's the opposite for current liabilities.

It's the same idea. If we had an increase in a current liability, well this is actually an increase in cash. So the idea here, I like to think about accounts payable. Let's say we had $100,000 in accounts payable last year and now this year's balance is $120,000. Well, that means we've loosened up some cash, right? Because we're able to owe our suppliers more money. Well, we're able to have more money available because we're saying, oh we'll pay you guys later, don't worry about it, and we've got more cash available now because we're paying them later. So an increase to a current liability is an increase to cash, and the opposite, a decrease to a current liability is a decrease to cash, right?

Because let's say we had owed $100,000 last year and now we only owe $80,000 well how could we have decreased that balance in accounts payable? By paying out cash, right? We would have lost some cash to decrease that balance.

So we're going to see in an example how to deal with this, in more details, but this should be a cheat sheet, just like I said. You're going to use this, this should be very handy when you're calculating the indirect method. Okay? So remember, once we've gone through all of those things, we are calculating our net cash inflow or outflow, if it's negative from operating activities. Okay. So all of this everything we just went through is just to calculate the net cash flow from operating activities. We're going to have a different lesson for investing activities, financing activities, as well as how to do the direct method, if you guys need to know that. Okay? So now that we know the steps, let's go through an in-depth example to see how this all works. Let's do it in the next video.

Indirect Method (1)

Alright, so on this next page we have some financial information for the ABC Company. We've got a comparative balance sheet showing last year's balance and this year's balance. This is going to be important for those changes in current liabilities and those changes in current assets. And then as we scroll down, we also have our income statement, right? And this is important because we need our net income and we need to be able to find depreciation expense and our gains and losses to calculate our operating cash flows. So, if you go to your next page, you're going to see that we have an example here. So this is going to be our in-depth example where we're going to calculate our cash flows from operating activities using the indirect method. And we're going to be using that balance sheet and that income statement from the previous page. Okay? So let's take it step by step. We're going to be using the indirect method and notice what we've got here. This is going to be this section of the cash flow statement. So notice we're only focused on the operating activities section of the cash flow statement here. So we're going to start with net income, and then we're going to make our adjustments based on the steps that I showed you on the first page, and then we're going to end up with our net cash provided or used by our operating activities. Okay? So let's go ahead and start with our net income. Where are we going to find our net income? Well, that comes from the income statement, right? And we'll go up to our ABC company income statement, and we'll find our net income right here. So step 1, right here. Net income is $145,000. Step 1 is done. Alright. We're well on our way to finding our net income or our operating cash flows here. So we're going to have a $145,000 as our starting point for our net income. Okay? And now we need to start making each of our adjustments. So we started here with net income. Next, we need to add back our non-cash expenses. So what are the non-cash expenses we're going to mostly look for? It's going to be depreciation expense or possibly amortization expense. Most of the time that's just going to be depreciation or they're going to be added together. They'll say depreciation and amortization. So we're going to be looking for depreciation expense here, because that's the only one that shows up on their on their income statement. Remember, this comes from the income statement. So we're going to scroll back up to ABC Company's income statement and we're going to look for those non-cash expenses and notice how they gave it to us here. They told us all the operating expenses, excluding depreciation, and then they told us depreciation separately here. Depreciation expense is $9,000. Okay? So we need to add back the $9,000 for depreciation expense. So we would have it here, we would have it listed depreciation expense, and we would put it in $9,000. We're going to make a separate column here for our adjustments. Let me make that line up there. $9,000. Okay. So that's our depreciation expense, and that came out to $9,000 here. Okay? Now let's do our effects of gains and losses, right? Step 3. Now before I go into the example above, I want to give you guys a little more clarity on why we remove the effects of gains and losses. So assume we had sold equipment for $8,000 and had accumulated $1,000 and we received $4,000 in cash from the sale. So notice, in this situation, we would have made a journal entry for cash for $4,000, right? So $4,000 would have been our cash debit, and we would have had to get rid of the accumulated depreciation and the cost of the equipment. So we would get rid of the accumulated depreciation with a debit for $1,000 and we would get rid of the equipment with a credit, right? Because it had a debit balance on our books, and now we're getting rid of it with a credit. So that gets the equipment off of our books, it gets the accumulated depreciation off of our books, and with the cash that was involved in the transaction. Finally, to balance this entry, we either have a loss or a gain. In this case, our credits are bigger than our debits, so we're going to have a loss. Right? So we would have had a loss on the sale of the equipment for $3,000. And that's what would balance out this equation. Right? And this loss would go to the income statement. But notice that that loss is not the cash amount. The cash amount is this $4,000, but that $4,000 would be an investing activity, right? Because this deals with the sale of a long-term asset. And as we discussed, long-term assets are investing activities. So in this case, this $3,000 loss on the income statement, it shouldn't be part of our operating activities. It had reduced our net income, but we need to get rid of that effect. Okay? So that's why we remove the effects of gains or losses. It would have been the same thing if we had a gain that would have affected our net income, but it wouldn't be the cash amount. The cash amount in these transactions should be investing activities, and we don't need those gains to be inside of our operating activity calculation. So let's go back up into our income statement, and let's see if there are any gains or losses to get rid of here. So right here, we have number 3, our loss on the disposal of plant assets. It's going to be this $3,000 right here. Just like in our example, we have a $3,000 loss, from the disposal of plant assets. So we need to get that out of our net income. So what do we need to do? We need to add back the loss. Right? The loss had decreased the loss on the sale of plant assets. We need to increase our net income by that amount, which was $3,000. So these are increases, right? We needed to add back depreciation, we needed to add back the loss on the sale of plant assets, and then that's all we need to do with the income statement. At this point, we've done the expenses and the gains or losses. Why don't we pause here and we'll finish up this example by dealing with the changes in current assets and the changes in current liabilities. Cool? Let's do that in the next video.

Indirect Method (2)

Alright, now let's continue our example with the changes in current assets, other than cash, and the changes in current liabilities. So this is going to come from the balance sheet. And remember, a change in a current asset, well, if we have an increase in current asset, it's a decrease to cash. It's going to be opposite. So a lot of times this can be confusing, especially when you get to a test and everything's very time crunch. So the way I like to think about this is to think assets equal opposites. Alright? It's kind of silly and it's kind of misspelled, but it's the way I like to think of it as a kind of a silly way to remember this thing. The assets are opposites when we come to our income statement, or excuse me, our cash flow statement. So what does that mean? An increase in current asset is a decrease to cash. Okay? So this is something silly I made up to help me remember this, and I hope it helps you, too. Assets are opposites when it comes to this stuff. Okay? So the reason this makes, it should make sense is if our, if our inventory balance, let's say, let's look at inventory. As an example here. So if inventory, let's say, had started at 100,000 and at the end of the year it was 120,000. That means we had net purchases during the year. It should have increased by 20,000 during the year. So how could it have increased by 20,000? That would be by buying more inventory, right? So we would debit inventory for 20,000 and credit cash for 20,000. Okay? So this is a simple example, but notice cash is decreasing when inventory is increasing. Okay? So yes, there are more things that go into an inventory calculation like cogs, other effects can go into inventory. But if there's a net increase to inventory, you can assume that we've increased our commitment to inventory by putting more cash into inventory. Okay? So that's exactly what's going on here. We're investing more of our cash into this inventory so we have less cash available. We're decreasing our cash there. Okay? And, and so if you remember that the assets are the opposites, right? Where we've got the increase in current assets is a decrease in cash or a decrease an increase to cash. They're opposites. Well, changes in current liabilities, they're just the other one. Okay? As long as you remember that the assets are opposites, the current liabilities is just going to be the other one. Where an increase to a current liability, current liability. I'm going to put liability, is an increase to cash. Okay? So those go hand in hand. They're not opposites. They go increase and increase. Where with an asset, it was increase and decrease, right? So let me show you in an example here, just like with inventory. Let's say it was accounts payable. Now we're talking about a current asset accounts payable where we had, let's say, a 100,000 starting balance in accounts payable. And the accounts payable, let's say, in this case went down. Well, we'll do an increase as well. A 120,000. Okay? So how did we increase? Well, this actually makes more sense when we do a decrease. It's easier to understand. So let's say it decreased to 80,000. Right? We had a 100,000 in accounts payable, and it decreased to 80,000. So that means we would have had to have some debit to accounts payable to decrease it by this 20,000 balance. So how would we decrease our accounts payable? By paying them off, right? We have accounts payable, these are accounts that we owe money to our suppliers. We have these debts to pay out. How do we get rid of those debts? Is to pay them, right? So we would in this case debit accounts payable for those 20,000 that we had paid off. And we would credit cash because we paid them in cash. So notice we decrease our accounts payable and we decrease our cash. So they go hand in hand in this situation, okay? So that's the best way to think of it. I like to just remember the assets are opposites and then boom, you can't forget it. Okay? So now let's go ahead, we'll pause here and in the next video, we'll finish up the example using this logic. Alright? Let's do that now.

Indirect Method (3)

Alright. Let's use this logic of our changes in current assets and changes in current liabilities to finish up our example. Alright? So let's go ahead and we're going to go back to our page with our balance sheet on it. We are going to look for changes in current assets and liabilities. That's what's going into this section to finally figure out what our operating cash flow is. Okay? The best way to do this is to go to your comparative balance sheet. In this example, I have included an extra column here, change in account balance. Now your professor doesn't have to give this to you. They could just give you this year's number and last year's number, and then you have to figure out the change in account balance. Sometimes they'll give you the change in account balance and you don't need to do this calculation at all. But we're going to do it every step of the way here. Okay?

The first thing we need to know is whether each account increased or decreased, and what the change in account balance was. Okay? Notice, in this problem, since we're only focused on operating cash flows, all we're going to calculate is the current assets and current liabilities. Okay? Sometimes it's necessary to find the changes in the investing accounts and in the equity accounts as well. But we're only focused on current assets and current liabilities, so let's do that just to save time here. And remember, we don't need to do cash. Cash is the point of the entire statement. Once we finish our entire statement, operating, investing, financing, our cash should show us the change in cash from the beginning balance of 33,000 to the ending balance of 55,000. Right?

So what we're focused on, as we saw in our example, is changes in current assets except cash and current liabilities. Let's check those out. Our accounts receivable, last year was 30,000 and now it's 20,000. So it's decreased by 10,000, okay? So, I'm going to put it in parentheses to signal that it was a decrease of 10,000. And our inventory, well, last year it was 21,000 and now it's 30,000. So our inventory has increased by 9,000, right? You see how I'm calculating this? We're just taking the difference between the two years and then we're going to say whether it's positive or negative using parentheses for negative numbers. Okay?

Let's check out our changes in current liabilities. So we've got two here, we've got accounts payable and income taxes payable. The first one is accounts payable. Last year it was 12,000; now it's 28,000. So we've had an increase of 16,000 from one year to the next. Income taxes payable last year were 8,000; now they're 6,000, so they've decreased by 2,000, right?

So, with the explanation I just gave, now we know the increase or decrease in each account. And if we remember that the assets are opposites and the liabilities go hand in hand, well, then we're just about done with our operating cash flows using the indirect method. Okay? So now we can go one by one. Let's start with accounts receivable; we saw that it was a decrease of 10,000. So, since assets are opposites, a decrease in accounts receivable means an increase to cash, right? So, the decrease of accounts receivable of 10,000 is an increase to cash of 10,000. The next one was inventory. We had an increase of inventory of 9,000. Since this is an asset and the assets are opposites, the increase in inventory means a decrease to cash, right? And that's going to be in the amount of 9,000. So now we've accounted for the inventory. We're done with our current assets. Let's do our current liabilities.

We had accounts payable and income taxes payable. Accounts payable, remember these go hand in hand. So an increase in accounts payable is an increase to cash in the amount of 16,000. So, we'll go down here and we'll say an increase in accounts payable in the amount of 16,000 is our increase there. Then there’s the income taxes payable where we had a decrease. A decrease in income tax payable, which is a current liability, is a decrease to our cash. So the 2,000 is going to be a decrease to our cash here, and guess what? We'll be finished at that point.

We just need to do our final calculation. First thing we're going to do is add up all of our adjustments. This is generally how we would show it on a statement. So we add 10,000 (decrease in accounts receivable, which increases cash) - 9,000 (increase in inventory, which decreases cash) + 16,000 (increase in accounts payable, which increases cash) - 2,000 (decrease in taxes payable, which decreases cash). We get a $15,000 change in cash during the period because of our operations. This could have been a positive number or a negative number; it just depends on what happened during the period. In this case, our adjustments totaled 15,000 and that's what we're going to add to our net income.

This total gives us a net cash provided from operations of $160,000. This is from starting with net income and then doing our adjustments for noncash expenses, gains and losses, and then changes in current assets and current liabilities. This is one of the tougher lessons that you have in the entire course. If you didn't get it on the first try, we've got some practice problems where you're going to get a little more experience with it. And you can always redo this video to see how the process flowed. As we go through your practice problems, go ahead and keep that first sheet handy where we have a summary of everything we just did, and go ahead and try and solve these practice problems. Alright? Let's go ahead and do that in the next session.

A company reported net income of $250,000. Depreciation and amortization totaled $120,000. In total, Current assets excluding cash increased by $25,000 and current liabilities increased by 16,000. The company also had a gain on the sale of equipment of $4,000. Using the indirect method, what are cash flows from operating activities?

• A. $357,000
• B. $365,000
• C. $375,000
• D. $383,000

A company had net income of $240,000. Depreciation expense was $36,000. During the year, the accounts receivable and Inventory increased $12,000 and $25,000, respectively. Accrued expenses and prepaid expenses decreased by $3,000 and $14,000, respectively. There was also a gain on the sale of equipment of $4,000. How much cash was provided by operating activities?

• A. $246,000
• B. $260,000
• C. $263,000
• D. $292,000

Here’s what students ask on this topic:

What is the Indirect Method for calculating Operating Cash Flows?

The Indirect Method for calculating Operating Cash Flows (OCF) starts with net income from the income statement and adjusts for non-cash expenses and changes in working capital. Non-cash expenses like depreciation are added back, while gains and losses from asset sales are adjusted. Changes in current assets and liabilities are also considered: increases in current assets indicate cash outflows, while increases in current liabilities suggest cash inflows. This method focuses solely on operating activities, distinct from investing and financing activities. Understanding these adjustments is crucial for accurate cash flow analysis, essential for effective financial management and decision-making in accounting.

Why do we add back depreciation in the Indirect Method?

In the Indirect Method, depreciation is added back to net income because it is a non-cash expense. Depreciation reduces net income on the income statement, but it does not involve an actual cash outflow. Since the goal of the Indirect Method is to determine the cash generated from operating activities, non-cash expenses like depreciation must be added back to net income to reflect the true cash flow. This adjustment ensures that the operating cash flows are not understated by non-cash charges.

How are gains and losses from asset sales treated in the Indirect Method?

In the Indirect Method, gains and losses from asset sales are adjusted because they do not represent actual cash flows from operating activities. A gain on sale increases net income but does not involve cash inflow from operations, so it is subtracted from net income. Conversely, a loss on sale decreases net income but does not involve cash outflow from operations, so it is added back to net income. These adjustments ensure that the operating cash flows reflect only the cash generated or used in the core business operations.

How do changes in current assets and liabilities affect Operating Cash Flows in the Indirect Method?

In the Indirect Method, changes in current assets and liabilities are crucial for adjusting net income to reflect actual cash flows. An increase in current assets (e.g., inventory) indicates a cash outflow, as cash is used to acquire these assets. Conversely, a decrease in current assets indicates a cash inflow. For current liabilities, an increase (e.g., accounts payable) suggests a cash inflow, as the company retains cash by delaying payments. A decrease in current liabilities indicates a cash outflow, as cash is used to settle these obligations. These adjustments ensure the operating cash flows accurately represent the cash generated or used in operations.

What are the main steps in calculating Operating Cash Flows using the Indirect Method?

The main steps in calculating Operating Cash Flows using the Indirect Method are: 1) Start with net income from the income statement. 2) Add back non-cash expenses like depreciation and amortization. 3) Adjust for gains and losses from asset sales by subtracting gains and adding losses. 4) Adjust for changes in working capital: subtract increases in current assets and add decreases, and add increases in current liabilities and subtract decreases. These steps help convert net income into net cash flow from operating activities, providing a clearer picture of the cash generated or used by the company's core operations.