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Cash Flow Analysis – Part II: Indirect Method

Key Takeaways:

  • How to prepare a cash flow statement using the indirect method, starting from net profit and adjusting for non-cash and non-operating items.
  • Step-by-step worked example, demonstrating each adjustment clearly.
  • Comparison of the direct and indirect methods in a concise table.
Cash Flow Analysis – Part II: Indirect Method

Source: Pixabay

Introduction

Understanding the Indirect Method of Cash Flow Analysis deepens your grasp of how profit transforms (or fails to transform) into actual cash. Accountants and analysts rely on this method because businesses often have significant differences between reported profit and cash generated from operations. These differences arise from non-cash expenses, accrued items, and non-operating gains or losses. The Indirect Method helps you bridge that gap, making you a more insightful Analyst or Auditor.

Indirect Method of Cash Flow Analysis

a. Concept and Steps

The Indirect Method begins with Net Profit before Tax and Extraordinary Items (from the income statement). You then adjust this figure for items that affected reported profit but did not involve cash, as well as items classified elsewhere on the cash flow statement.

  • Add back non-cash expenses: These include depreciation, amortization, and provisions. They reduce profit but don’t use cash.
  • Add back non-operating losses: For example, loss on sale of assets (since the cash effect is shown under Investing Activities).
  • Subtract non-operating gains: E.g., profit on sale of investments (again, the cash impact is Investing, not Operating).
  • Adjust for changes in working capital: These are the changes in current assets and current liabilities (excluding cash and equivalents).

This process converts accrual-based net profit into actual cash generated from operating activities.

b. Typical Adjustments in Practice

  • Depreciation and Amortization: Always added back.
  • Provisions (e.g., for doubtful debts): Added if charged to P&L.
  • Gain on Sale of Fixed Assets: Subtracted.
  • Interest Paid: Sometimes classified as operating; if not, adjust accordingly.
  • Increase in Current Assets (other than cash): Subtracted (more cash tied up).
  • Decrease in Current Assets: Added (cash released).
  • Increase in Current Liabilities: Added (cash preserved).
  • Decrease in Current Liabilities: Subtracted (cash paid out).

Example

Let’s walk through a step-by-step illustration. Assume the following figures are extracted from a company’s financial statements:

  • Net Profit before Tax: ₹1,00,000
  • Depreciation: ₹20,000
  • Amortization of Goodwill: ₹5,000
  • Loss on Sale of Machinery: ₹2,000
  • Profit on Sale of Investments: ₹3,000
  • Increase in Debtors: ₹10,000
  • Decrease in Inventory: ₹8,000
  • Increase in Creditors: ₹6,000
  • Decrease in Outstanding Expenses: ₹4,000

Here’s how you’d prepare the cash flow from Operating Activities (Indirect Method):

Particulars
Net Profit before Tax 1,00,000
Add: Depreciation 20,000
Add: Amortization of Goodwill 5,000
Add: Loss on Sale of Machinery 2,000
Less: Profit on Sale of Investments (3,000)
Operating Profit before Working Capital Changes 1,24,000
Less: Increase in Debtors (10,000)
Add: Decrease in Inventory 8,000
Add: Increase in Creditors 6,000
Less: Decrease in Outstanding Expenses (4,000)
Net Cash from Operating Activities 1,24,000 - 10,000 + 8,000 + 6,000 - 4,000 = ₹1,24,000

Pause and think: Why do we add back depreciation and subtract the increase in debtors?
Because depreciation doesn’t use cash, but more money tied up in debtors means less cash in hand. This illustrates the heart of the Indirect Method which is translating accrual profit into real cash movement.

Direct vs Indirect Method

Feature Direct Method Indirect Method
Starting Point Cash receipts and payments Net profit (from Income Statement)
Adjustments Needed Not required, uses actual cash flows Adds/removes non-cash and non-operating items
Complexity Requires detailed cash records Relies on existing accrual-based statements
Usage Less common (except for some regulatory filings) Most widely used in practice
Clarity Greater transparency of cash transactions Shows reconciliation of profit to cash

The Indirect Method provides a natural bridge between reported profits and cash movements. Always remember that cash flow analysis is about understanding the business beneath the numbers.



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