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Indirect Method (GAAP)
The Statement of Cash Flows is an effective tool in understanding the financial ability of a company to survive and repay debt. The Financial Accounting Standards Board in 1987 decided that it was so important that they eliminated the statement of changes in working capital and replaced it with the Statement of Cash Flows. There are two methods of preparing a Statement of Cash Flows under FASB 95, the direct method and the indirect method. Both methods divide the Statement of Cash Flows into three sections: operating activities, investing activities and financing activities. The last two sections, investing activities and financing activities are treated identically under the two methods. Operating activities are treated very differently, though the result, cash flow from operations, is identical under either approach.
The statement of Cash Flows under the Indirect Method (or Reconciliation Method) is the easiest to prepare and understand. Under the indirect approach, net income is adjusted by non-cash activities to derive the change in cash,
Net Income/(Net Loss) - Non-Cash Activities = Cash Activities
Operating Activities + Investing Activities + Financing Activities = Change in Cash
Beginning Cash + operating activities + financing activities + investing activities = Ending Cash
Increasing assets takes cash, decreasing assets produces cash. For example, to purchase inventory cash must be expended, when inventory is sold it creates cash.
Increasing liabilities provides cash, decreasing liabilities takes cash. Borrowing money increases cash. Paying off debt takes cash.
Cash
Accounts Receivable
Inventory
Gross Fixed Assets
Accumulated Depreciation
Net Fixed Assets
Total Assets
Accounts Payable
N/P - Bank
Total Liabilities
Equity
Gross Sales
Depreciation
Net Income
Year 1
$ 20,000
30,000
10,000
$ 60,000
$ 100,000
60,000
$ 40,000
$100,000
$ 25,000
30,000
$ 55,000
$ 45,000
$100,000
20,000
$ 15,000
Year 2
$ 25,000
50,000
8,000
$ 83,000
$117,000
80,000
$ 37,000
$120,000
$ 43,000
35,000
$ 78,000
$ 42,000
$115,000
20,000
$ 5,000
Operating Activities
Net Income
Depreciation
Accounts Receivable
Inventory
Accounts Payable
CF from Operations
Investing Activities
Purchases
CF from Investing Act
Financing Activities
N/P - Bank
Dividends
CF from Financing Act
Change in Cash
$ 5,000
20,000
(20,000)
2,000
18,000
$ 25,000
($ 17,000)
($ 17,000)
$ 5,000
( 8,000)
($ 3,000)
$ 5,000
Beginning A/R
+ Sales
- Collections
Ending A/R
Inventory - BB
+ Purchases
- COS
Inventory - EB
In this example, ABC Corporation generated positive cash flow from operations of $25,000. An increase in account receivable absorbed $20,000 of cash, while an increase in accounts payable provided $18,000 of cash. Non-cash charges or depreciation generated $20,000 of positive cash flow. Investing activities consisted of $17,000 in equipment purchases. ABC borrowed $5,000 in bank debt and paid dividends of $8,000, absorbing net cash flow from financing activities of ($3,000).
In this situation, ABC generated a positive cash flow from operations that is more than sufficient to support dividend payments of $8,000 and the purchase of equipment of $17,000.