How to Prepare a Cash Flow Statement Using the Indirect Method

Introduction

Cash Flow Statements provide an analysis of a company's cash inflows and cash outflows over a certain period of time, usually a quarter or year. The Indirect Method is a common method of preparing cash flow statements, which involves calculating net income first, then adjusting for items that don't include actual cash flows like depreciation.

In this article, we will discuss how to prepare a Cash Flow Statement using the Indirect Method in detail, including the following topics:

• Definition of the Indirect Method
• Overview of the Cash Flow Statement
• Steps for Preparing a Cash Flow Statement Using the Indirect Method
• Reporting in the Cash Flow Statement

Analyzing Operating Activities

In order to prepare a cash flow statement using the indirect method, one of the key steps is to analyze the operating activities. To do so, we must first summarize net income, followed by expenditures below net income.

Summarizing Net Income

The starting point for analyzing operating activities is to summarize net income. All income and expenses must be included in this summary, leaving us with a figure we can use to move forward in our cash flow statement. Additionally, any non-cash items such as income tax payment or depreciation should be excluded, as these items do not have an impact on the actual cash flow.

Expenditures Below Net Income

In addition to summarizing net income, we must also consider expenditures below net income. In order to accurately portray the actual cash flow, any expenses that were not included in the income and expenses must be taken into account. This can include such non-operating expenses as income tax payments, dividends, or capital expenditure.

To calculate the right amount of cash flow, these expenditures must be included alongside any net income. This must be done in order to ensure that the cash flow statement accurately reflects the actual cash flow.

Accounting Changes Affecting Operating Activities

Before preparing a cash flow statement, you must consider all regulations surrounding accounting changes that may impact your operating activities. These changes can involve the capitalization of long-term assets, capitalization of expenses, or reclassification of costs.

Capitalizing Long-term Assets

To capitalize long-term assets, your company needs to recognize the costs of acquisition and installation of the assets. This includes everything from research and development costs to the cost of assembly and installation. When capitalizing long-term assets, companies must also factor in costs associated with repairs and renovations that may have been done to the asset to extend its useful life.

Capitalizing Expenses

When preparing a cash flow statement, your company also needs to consider any capitalized expenses that would not be included in the income statement. Such expenses include costs of software development, website development, and other expenses related to research and development that should be amortized. These expenses should be included in the cash flow statement under the capitalization of non-current assets.

Reclassifying Costs

It may also be necessary to reclassify some operating costs to comply with Generally Accepted Accounting Principles. This could involve reclassifying variable costs into fixed costs or vice versa, or reclassifying certain costs as capitalized expenses. For example, if a company develops software, they may initially treat the software development cost as an operating expense. However, after accounting treatment, such costs should be capitalized and included as an asset, instead of an expense.

• Capitalizing long-term assets
• Capitalizing expenses
• Reclassifying costs

Non-Operating Cash Flows

When preparing a cash flow statement using the indirect method, attention must be given to non-operating cash flows which are generated by the company operations away from the company's main business.

Dividends Paid

Dividends paid refers to distribution by the company to its shareholders, usually as part of the payout following the end of the financial year. For the indirect method, dividend payments must be subtracted from the net income, as the payments represent a cash outflow for the company that is not related to its operations.

Interest Paid

Interest paid is a key component of debt servicing, and is deductible according to the indirect method. Companies that have taken out loans and debts use the interest payment amounts to reflect the cost of borrowing and debt servicing. This cost is reported on the cash flows statement and is classified as a non-operating cash flow.

Interest payments should be deducted to arrive at the net income after taxes, and the payment value should be reported in the cash flows statement.

Analyzing Ending Cash Balances

At this point, you should have a completed cash flow statement using the indirect method. As your final step, you'll need to analyze the ending cash balances of the statement. You'll need to first adjust for any differences between assets and liabilities. Then, you'll need to reconcile any differences between the two figures.

Adjusting for Assets/Liabilities

In order to compare cash flow to the actual money of the company, you must make sure that the assets and liabilities match. Typically, you can see clearing or refund balances in the asset and liability sections. To adjust for these amounts, take the difference between the assets and liabilities and add it to the right hand side (the cash portion) of the statement. This will bring the total into balance.

Reconciling Differences

Once the statement is in balance, it is time to reconcile any differences. You'll need to look at the opening and closing cash balances that are listed at the start of the statement. The difference between the two should be equal to the total cash flow generated in the statement in the same period of time. If any discrepancies arise, use the variance section of the statement to determine the issue.

Take extra care to double-check the accuracy of your statements before submitting for further review or filing with the necessary authority.

Preparing a Statement of Cash Flows

Preparing a statement of cash flows can be an important part of managing a business's finances. The indirect method of preparing a statement of cash flows takes into account a business's profit and loss statement, as well as its balance sheet. This makes it possible to track and analyze the sources and uses of cash over a period of time. In order to create a statement of cash flows using the indirect method, there are several steps that must be followed.

Preparing Header Information

The first step in preparing a statement of cash flows using the indirect method is to prepare the header information. This includes the title of the statement, which should list the name of the company and the period of time the cash flows will cover. The next step is to prepare the operating activities section of the statement, which should list any cash flows related to the business's operations over the period of time. It is also important to add any beginning cash balances to the statement to provide a full picture of the cash flow for the period.

Computing Cash Flows

Once the header information is prepared, the next step is to compute the cash flow. This involves going through the balance sheet and profit and loss statement for the period and making any necessary adjustments. This includes adjusting for depreciation, making any inventory adjustments, and recognizing any cash received from investments. It is also important to list any taxes or interest that have been paid out during the period. Once all of these adjustments are made, the resulting cash flows should be listed on the statement.

Preparing a Final Report

The final step in preparing a statement of cash flows using the indirect method is to prepare the final report. This should include the operating, investing, and financing activities sections of the statement, as well as a summary of the cash flows over the period. Any beginning and ending cash balances should be included in the report, as well as any related notes. Once the statement is complete, it can be reviewed by management for accuracy and to ensure that all of the necessary information has been included.

Conclusion

Preparation of a cash flow statement using the indirect method is a great way to accurately and efficiently gain a holistic understanding of financial performance. By following the steps outlined in this blog post, users now have the knowledge and the tools to quickly generate a cash flow statement using the indirect method.

Benefits of Using the Indirect Method

• It is more reliable than the direct method.
• It provides users with useful information to enhance decision-making.
• It helps users to visualize a company’s cash inflows and outflows on a concisely formatted statement.

Gaining a Deeper Understanding of Finances

The indirect method is the most widely accepted method for preparing cash flow statements and provides users with a better understanding of the company’s financial performance. By utilizing the indirect method, users can gain a deeper insight into the financial statements of a company and the implications of the changes that have been made in the past.

The indirect method is a useful tool that assists users in gaining a better understanding of their finances. By utilizing this method, users can gain an in-depth view into the performance of their company, track the progress made and make better financial decisions in their business.