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Cash Flow Banner

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. 

Accounts Receivable

Gross Fixed Assets
Accumulated Depreciation
Net Fixed Assets

Total Assets

Accounts Payable
N/P - Bank 
Total Liabilities 


Gross Sales
Net Income

Year 1

$  20,000
$  60,000

$ 100,000
$  40,000


$ 25,000
$ 55,000

$ 45,000

$ 15,000

   Year 2

$  25,000
$  83,000

$  37,000


$ 43,000
$ 78,000

$ 42,000

$   5,000

Operating Activities
Net Income
Accounts Receivable
Accounts Payable 
CF from Operations

Investing Activities
CF from Investing Act

Financing Activities
N/P - Bank
CF from Financing Act

Change in Cash



$    5,000
$  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
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.  

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