Prepare A Cash Flow Statement | Indirect Method

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 using the direct method what it looks like and how to calculate all of the numbers using an example hey viewers I'm James and welcome to another episode of accounting staff if you're new here this is the channel where we post weekly videos teaching accounting basics if that's something they might interest you you get that subscribe button to avoid missing out 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 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 summarize the movement of the cash balance in a balance sheet over a period of time typically a quarter or a year and we do this by summarizing 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 sessions cash flow from investing and financing activities are completely identical whether using the direct or indirect method the only section is 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 in 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 in the right 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 accounts using the accrual basis which means their profit does not equal their net cash inflow under the accrual basis revenue is recognized 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 amortization 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 of business has less cash because it has bought more inventory than it is 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 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 Pebbles 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 categorized 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 well that is practiced 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 gonna show you how to do it using the indirect method instead I'm starting right now step one 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 two 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 amortization 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 three we need to adjust 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 planned popteen equipment is a non and acid 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 to 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 Calchas well that's the movement in our current assets but we also need to bind 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 are suggested by their name our non current liabilities which relate to cash flow from financing activities so we can ignore them here where 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 a hundred and fifty six and the sum of their opening balances is a hundred and thirty one 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 seventy thousand dollars 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 layouts 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 as 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 then I recommend you check out the other two videos that I made that a link below thanks for watching we have new videos every Monday here on counting stuff if you found this one useful give it a like share it comment subscribe if you haven't already good luck for 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 [Music] you

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Keywords: indirect method, cash flow accounting, direct or indirect method, indirect method cash flow, cash flow statement, cash flow, statement of cash flows, cash flow statement indirect method, cash flow statement indirect method example, indirect method cash flow statement, accounting stuff, accounting basics, accounting basics cash flow, accounting basics for beginners, accounting, what is indirect method of cash flow, indirect cash flow, how to prepare a cash flow statement

Id: 8CH-6wdfz0Y

Length: 11min 14sec (674 seconds)

Published: Mon Dec 17 2018