BU.210.620 Chap.3 Statement of Cash Flows and the Indirect Method
Statement of Cash Flows and the Indirect Method
Why a third statement
Net income and cash move apart for three reasons the course stresses: accruals leave uncollected sales and unpaid bills inside income, non-cash expenses such as depreciation and impairment reduce income without using cash, and some cash movements, buying equipment or issuing shares, never touch the income statement.
The statement of cash flows explains the change in cash and cash equivalents, which are highly liquid investments with an original maturity of generally three months or less.
Three activities
Operating activities are cash flows tied to earning income, including interest and dividends received and interest paid under US GAAP.
Investing activities cover buying and selling productive assets and other firms' securities, even short-term investments. Financing activities cover owners and lenders: borrowing and repaying principal, issuing and repurchasing shares, and paying dividends.
Events with no cash, such as issuing shares for land, are left out of the three sections, and amounts are reported gross.
The indirect method
The course prepares the operating section indirectly, as most US companies do, because that layout shows exactly why income and cash differ.
Start from net income, add back depreciation, amortisation and impairment, subtract gains and add losses on asset sales because the full proceeds sit in investing, then adjust for working capital. Increases in receivables, inventory and prepaid expenses are subtracted; increases in accounts payable and accrued expenses are added; decreases reverse the sign.
The three section totals must reconcile beginning cash to the ending balance sheet figure.
Reading the signs
The pattern of signs across the three sections tells a story about the company's stage. Start-ups often burn operating cash while mature firms generate it; growing firms show negative investing flows as they add capacity. Rising income with falling operating cash is a pattern analysts question.
Companies fund growth from three sources, operating cash, new shares and long-term borrowing, and the financing section shows which one a firm relied on.
What this chapter covers
- 01
Why cash differs from net income
- 02
Cash and cash equivalents
- 03
Operating, investing and financing activities
- 04
Indirect-method adjustments
- 05
Gains, losses and noncash transactions
- 06
Interpreting cash flow patterns
Worked example · free
Build an operating section from net income
- 2Non-cash and disposal items: 120,000 + 30,000 depreciation + 4,000 loss = 154,000.
- 2Current assets: add the 6,000 fall in receivables, subtract the 15,000 rise in inventory.
- 2Current liabilities: add the 9,000 rise in payables, giving operating cash flow of $154,000.
Key terms
- Cash equivalents
- Cash equivalents are investments so liquid and so near maturity, generally three months or less when bought, that the statement treats them as cash.
- Operating activities
- Operating activities are the cash inflows and outflows directly related to earning net income from normal operations.
- Financing activities
- Financing activities are cash exchanges with owners and lenders: borrowing and repaying principal, issuing or buying back shares, and paying dividends.
- Noncash transaction
- A noncash transaction is an investing or financing event with no cash exchange, such as issuing shares for land, and it is excluded from the three sections.
Statement of Cash Flows and the Indirect Method FAQ
Why is a gain on sale subtracted in the operating section?
The entire sale price is already reported as an investing inflow. Leaving the gain inside net income would count part of the same cash twice, so the indirect method removes it from operating activities.
Where does interest paid go under US GAAP?
Operating activities, because interest expense is part of net income. Repayments of the loan principal itself are financing outflows, which is a frequent source of misclassified answers.
Can operating cash flow be negative for a healthy company?
Yes, especially early in its life, when it is building receivables and inventory faster than it collects cash. A mature company with persistently negative operating cash flow deserves closer scrutiny.
How do the direct and indirect methods differ?
The direct method lists operating receipts and payments line by line, such as cash from customers and cash to suppliers. The indirect method starts from net income and adjusts it. Both produce the same operating total.
Exam move
Memorise the adjustment directions as sentences, not signs: receivables up means customers paid less than revenue. Then practise reconciling each finished statement to the ending cash on the balance sheet until the tie-out is automatic, and redo one statement using the direct method to confirm both routes land on the same operating total.
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