How would you prepare a statement of cash flows using the indirect method, considering the adjustments needed for non-cash transactions and changes in working capital?
The indirect method of preparing a statement of cash flows starts with net income and adjusts it to arrive at cash flow from operating activities. Here's a breakdown of the process, including adjustments for non-cash transactions and changes in working capital:
1. Start with Net Income: Begin with the net income reported on the income statement.
2. Adjust for Non-Cash Items: Non-cash transactions, which don't involve the exchange of actual cash, are added back or subtracted from net income. Common examples include:
Depreciation and Amortization: These expenses are deducted on the income statement but don't involve cash outflow. They are added back to net income.
Gains or Losses on Sale of Fixed Assets: Gains are subtracted, and losses are added back.
Changes in Deferred Revenue: Increases in deferred revenue represent cash received but not yet earned, so they are subtracted. Decreases are added back.
3. Adjust for Changes in Working Capital: Working capital represents current assets minus current liabilities. Changes in working capital impact cash flow. Here's how:
Increases in Current Assets (excluding cash): Increases in accounts receivable, inventory, or prepaid expenses indicate cash used in operations and are subtracted.
Decreases in Current Assets (excluding cash): Decreases in accounts receivable, inventory, or prepaid expenses indicate cash generated from operations and are added.
Decreases in Current Liabilities: Decreases in accounts payable, accrued expenses, or unearned revenue indicate cash used in operations and are subtracted.
Increases in Current Liabilities: Increases in accounts payable, accrued expenses, or unearned revenue indicate cash generated from operations and are added.
Example:
Imagine a company with the following information:
Net Income: $100,000
Depreciation Expense: $20,000
Increase in Accounts Receivable: $10,000
Decrease in Accounts Payable: $5,000
The calculation for cash flow from operating activities using the indirect method would be:
Net Income: $100,000
Add: Depreciation Expense: $20,000
Subtract: Increase in Accounts Receivable: $10,000
Subtract: Decrease in Accounts Payable: $5,000
Cash Flow from Operating Activities: $105,000
4. Cash Flows from Investing Activities: This section reflects cash flows related to acquiring and disposing of long-term assets. Examples include:
Purchase of Property, Plant, and Equipment (PP&E): Outflows are subtracted.
Sale of PP&E: Inflows are added.
Investments in Other Companies: Outflows are subtracted.
Proceeds from Investment Sales: Inflows are added.
5. Cash Flows from Financing Activities: This section reflects cash flows related to financing the business through debt, equity, and dividends. Examples include:
Issuance of Bonds or Stock: Inflows are added.
Repayment of Debt: Outflows are subtracted.
Payment of Dividends: Outflows are subtracted.
6. Net Increase (Decrease) in Cash: Sum the cash flows from operating, investing, and financing activities to determine the overall change in cash during the period. This is added to the beginning cash balance to arrive at the ending cash balance.
Remember, the indirect method focuses on reconciling net income to cash flow from operations. It provides insights into the company's ability to generate cash from its core business activities. The indirect method is often used alongside the direct method for a more comprehensive understanding of a company's cash flows.