In this video you'll learn how to
prepare a cash flow statement using the indirect method.
I'll show you how this way is different to using the
direct method. What it looks like?
And how to calculate all of the numbers using an example.
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Hey viewers
I'm James and welcome to another episode of Accounting Stuff.
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In this video we're going to cover preparing a cash flow statement
using the indirect method. I've made a couple of videos on
the direct method already where I explained the format
and purpose of the cash flow statement
and how to prepare it using T accounts.
Link up here if you missed either of those.
This week we're going to use the same example
income statement and balance sheet as we did
last time.But we're going to prepare it using the indirect method instead.
I recommend that you watch this video through to the end
because I'm going to take you through all of the calculations
step-by-step so that you'll have no problem putting one of
these together by yourself. So without further ado
let's get started… So what's the difference between
the direct and indirect method anyway?
The cash flow statement along with the income statement and the
balance sheet make up the three major financial statements.
We use the cash flow statement to summarise the movement
of the cash balance in the balance sheet over a
period of time. Typically a quarter, or a year.
And we do this by summarising all of the cash inflows and
outflows into three categories. Cash flow from operating activities
cash flow from investing activities and cash flow from financing activities.
The latter two sections… Cash flow from investing and
financing activities… are completely identical whether
you are using the direct or indirect method.
The only section that’s different is cash flow from operating activities.
Which is why I want to focus on that one in this video.
If you'd like to learn more about investing and
financing activities… I've covered them in more detail
in the previous two videos that I'll drop a link to down in
the description. Operating activities are the
principle revenue generating activities of a business.
These are the transactions that take place on a regular basis.
Under the indirect method there are three steps to calculating
cash flow from operating activities. And I'll take you through them
right now.
First of all we need the businesses
net profit or loss which we can find in the income statement.
This method relies on starting off with net profit and adjusting it for
non-cash transactions again and again until we're left with only
net cash inflow or outflow. Most large companies account
using the accrual basis which means their profit does not equal their
net cash inflow. Under the accrual basis…
Revenue is recognised when it's earned, not when cash is received.
And expenses are recorded as they are incurred,
not when cash is paid out. So revenue doesn't equal
cash inflow and expenses don't equal cash outflow.
Which brings us on to the second section.
We need to add back all of the non-cash expenses that exist
in the P&L. Typically non-cash items
relate to things like depreciation, amortisation or the gain or loss on
disposal of non current assets. These don't represent cash outflows
but they are deducted in our income statement when coming
to that net profit. So it's logical that we need
to add these back in order to remove them from our
calculation. The third and final step
is that we need to adjust for the movement in working capital.
Working capital is simply current assets less
current liabilities. Current assets are generally
made up of inventory and receivables whereas current liabilities are made up
of payables. To work out whether you need
to add or subtract these movements in the calculation.
You need to consider the impact they have on the cash balance.
An increase in inventory means a business has less cash
because it has bought more inventory than it has sold,
and on the flip side… A decrease in inventory means
a business has more cash because it has sold more inventory
than it has bought. The situation with accounts receivable
are very similar because they are also assets.
An increase in receivables means less cash has been recovered from
customers so the cash balance goes down. And a decrease in receivables means more
cash has been collected so the cash balance goes up.
On the other hand… Payables are a liability so they work
the opposite way to the inventory and accounts receivable.
An increase in payables
means more cash because less has been paid out to suppliers
who the business owes money to. And lower payables means less cash
because more has been used to pay the bills.
Cash flows from non current assets and non current liabilities tend
not to be included on the cash flow from operating activities
because they're normally categorised in the other two sections.
Cash flows from investing activities and cash flows from financing activities.
Now that we've worked out the basic calculation for
cash flow from operating activities. Let’s practice using this
template with a worked example.We will continue with that
Chudley Canon's example that I took you through in the previous
two videos. Last time I showed you how to
calculate cash flow from operating activities with the
direct method and today I'm going to show you how to do it
using the indirect method instead, and we're starting right now.
Step 1 We first need to jot down the
net profit figure because this is our starting point that we will make
adjustments to in order to come to that net cash flow.
Net profit can be found easily at the bottom of the
income statement. In this case,
the Canons have made a net profit of $70,000 for the year
so we write this down at the top of the calculation.
Next we have Step 2 This is where we need to add back all of
those non-cash expenses that are shown in the income statement.
We've got to reverse these out of our net profit in order to get closer
to the cash flow figure.
To do this we look over the
income statement and search for any depreciation, amortisation or gain or
loss on disposal of non current assets. In this case we can only see
depreciation of $23,000. So we need to add back 23 into our
calculation to adjust for depreciation. Finally in Step 3
We need to adjust for the movement in working capital.
Like I said before… Working capital is made up
of current assets less current liabilities.
Let's have a look over the balance sheet and see what
current assets we have. I can see cash,
accounts receivable, and inventory.
Plant Property & Equipment is
a non current asset which affects
cash flow from investing activities. So we can ignore that.
And cash is what we're reconciling back to in the cash flow statement.
So we can ignore that one as well. We are left with only inventory
and accounts receivable.
A closing balance in inventory of 94,
less the opening balance of 68, gives us an increase in
inventory of 26. Increases in inventory are
represented as deductions in calculating cash flow from operating activities
because the business has spent cash on purchasing the raw goods or by
manufacturing them. So we enter negative 26
into our calculation. Now let's look at accounts receivable.
Here we have a closing balance of a hundred and twenty,
and an opening balance of ninety eight, which gives us an
increase of twenty two during the course of the year.
Increases in accounts receivable need to be deducted from our
net profit in calculating the cash flow from operating activities
because higher receivables means that less cash has been recovered
by the business from its customers. So we enter negative 22 into
our calc as well. That's the movement in our
current assets but we also need to find the movement in our current liabilities
so that we've considered all of the working capital.
Reviewing the balance
sheet one more time shows us that
our current liabilities are made up of accounts payable,
salaries payable, interest payable,
and income tax payable.
Long term borrowings as suggested by their name
are non current liabilities.
Which relate to cash flow from financing activities.
So we can ignore them here.
Whereas share capital and retained earnings
relate to equity.
So these can be excluded as well.
We are left with only these four current liabilities.
The sum of their closing balances is 156 and the sum of their
opening balances is 131.
When we take the difference between these numbers
we have an increase in payables of $25,000
during the year. Increases in payables need to be
added to our net profit in order to calculate cash flow.
That makes sense
because you can imagine that if a business
doesn't pay us invoices then it gets to hold on to its cash.
So we add back
25 in our workings.
Boom!
That steps one two three completed. All that we need to do now
is take the total of those numbers and we're left with the net
cash inflow from operating activities of $70,000.
That wasn't so bad was it?
We've come to this number using the indirect method.
But a quick check of our calculations using the direct method
shows that we also came to $70,000 of cash inflow from operating activities.
We get the exact same answer using either technique.
So which is better? If you've watched my other videos
on the direct method then you'll notice that
the indirect method is much much quicker!
Which is why most large companies using the accrual basis of accounting tend to
work out their cash flow this way. But if that's case then why doesn't
everyone do this? I suppose it really comes down to
how the workings of cash flow from operating activities are presented in
the cash flow statement. The layout using the direct method
is far more intuitive to read because it mirrors the cash basis
income statement.
We have the cash receipts from customers at the top,
and below that we have the cash paid out to all of the various suppliers and
stakeholders.
It makes easy reading for investors who might be glancing over the
cash flow statement to extract meaningful information from it.
On the other hand...
The layout of cash flow from operating activities under
the indirect method is far less intuitive.
You can think of the indirect method
as a shortcut to working out cash flow from operating activities.
Which is a win for the accountant or bookkeeper who's preparing it,
because it saves them time. However the third parties who are
viewing the finished cash flow statement lose out because this report isn't
as useful to them.
Like I mentioned earlier, we skipped over
cash flow from investing and financing activities in this video.
Because these sections are identical under the direct method.
If you'd like to learn
more about those or the cash flow statement in general,
then I recommend you check out the other two videos
that I made that are linked below.
Thanks for watching! We have new videos every Monday
here on Accounting Stuff! If you found this one useful…
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comment, subscribe if you haven't already.
Good luck with those cash flow statements!
This is an area that
a lot of people struggle with.
But I promise if you follow the steps that
I just showed you you'll be fine.
See you next time!
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