How to calculate Cash From Operating Activities (or CFOA) using the indirect method.
Let me take you through a short and simple example of how to construct a cash flow statement.
This video covers the indirect method of cash flow reporting, a companion video will cover
the direct method.
When you use the indirect method, you start off with net income, or net profit.
You can find net income in the P&L, the profit and loss statement, which could also be called
the income statement.
It is the bottom line of the income statement.
In this example, net income is 112.
Next step in the indirect method is to look for any non-cash items in that P&L.
In this example, the only non-cash item is depreciation, which is 20.
Depreciation is the accounting process of allocating the purchase price of tangible
assets to current expense.
As you do not pay depreciation to anyone, but instead deduct the amount of depreciation
from the P&E or fixed assets balance on the balance sheet, finance people would call this
a non-cash item.
You deducted depreciation as an expense in order to report the correct amount of EBIT
and profit before tax, and calculate the correct amount of corporate income taxes.
For cash flow purposes, you will have to add back that same amount of depreciation.
If you review the annual report of a company listed on the stock market, you could come
across other non-cash items that you need to adjust for, such as stock-based compensation.
The next step in using the indirect method of cash flow reporting, is to review the opening
balance sheet of the year versus the closing balance sheet of the year.
More specifically, you calculate the deltas in working capital, the increases or decreases.
If inventory goes up, then cash goes down.
This is called a use of cash of in this case 50.
If receivables stay the same year-over-year, then there is no net impact on cash.
If payables go up, then cash goes up.
In a way, your supplier is partly financing your operation.
This is called a source of cash, of in this case 50.
Let's summarize the items we have found so far.
In the indirect method of cash flow reporting, you start off with net income of 112,
you add back non-cash items such as depreciation of 20, and then list the changes in working capital.
In this example, the total change in working capital is zero, but underlying to that is
an increase in the inventory balance which is seen as a cash outflow, and an increase
in the accounts payable balance which is seen as a cash inflow.
Total net cash provided by operating activities is 132.
To complete this example, and build the full cash flow statement, let's look for any clues
on the lines of Cash From Investing Activities (CFIA) and Cash From Financing Activities (CFFA).
In this example, to keep things simple, nothing is happening in either of those lines.
In real life, for a mature and successful company, there would probably be a
CapEx cash outflow in CFIA, and a dividend cash outflow in CFFA.
If you add up the three categories, Cash From Operating Activities,
Cash From Investing Activities and Cash From Financing Activities,
you get to the net increase or decrease in cash.
Please note that you have not yet completed the full cash flow statement!
An important step is to check on the balance sheet what the amounts were of the opening
cash balance and the closing cash balance.
Opening cash was 60, closing cash was 192.
The net increase or decrease in cash that you calculated should be the difference between
these two balances.
The last step in constructing your cash flow statement is to show just that: the net increase
in cash of 132, plus the opening cash of 60, equals the closing cash balance of 192.
Done!
I have a lot of material available on the Finance Storyteller YouTube channel that can
help you get a good understanding of the topic of cash flow and related items.
For example, I have full walk-throughs for you of the cash flow statements of Shell,
Tesla and Walmart.
I think the best way to learn how to read a cash flow statement is to go through as
many real-life examples as you can!
Thank you for watching!
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