Prepare A Cash Flow Statement | Indirect Method

How to Prepare a Cash Flow Statement Using the Indirect Method

Introduction to Cash Flow Statements

• In this video, James introduces the concept of preparing a cash flow statement using the indirect method, highlighting its differences from the direct method.

• The channel focuses on teaching accounting basics and encourages viewers to subscribe for weekly content.

Overview of Cash Flow Statement Components

• The cash flow statement is one of three major financial statements, alongside the income statement and balance sheet, summarizing cash movements over time.

• It categorizes cash flows into operating activities, investing activities, and financing activities; only operating activities differ between methods.

Understanding Operating Activities

• Operating activities are essential revenue-generating transactions that occur regularly within a business.

• The focus will be on calculating cash flow from operating activities using the indirect method.

Steps in Calculating Cash Flow from Operating Activities

Step 1: Start with Net Profit or Loss

• Begin with net profit or loss from the income statement as it serves as the starting point for adjustments.

Step 2: Adjust for Non-Cash Transactions

• Add back non-cash expenses such as depreciation and amortization since they do not represent actual cash outflows but affect net profit.

Step 3: Adjust for Changes in Working Capital

• Consider movements in working capital (current assets minus current liabilities), which impact cash balances:

• An increase in inventory indicates less cash available due to purchases exceeding sales.

• A decrease in inventory suggests more cash availability due to sales exceeding purchases.

Impact of Receivables and Payables on Cash Flow

• Accounts receivable increases mean less collected cash; decreases indicate more collected cash.

• For payables, an increase means more available cash (less paid out), while a decrease indicates less available cash (more paid out).

Exclusions from Operating Activities Calculation

• Cash flows related to non-current assets and liabilities are typically categorized under investing or financing activities rather than operating activities.

Practical Application: Worked Example Using Indirect Method

Starting Point: Net Profit Figure

• The example continues with Chudley Canon's figures where net profit is noted at $70,000 as a basis for further calculations.

Adding Back Non-Cash Expenses

• Next steps involve identifying non-cash expenses listed in the income statement that need reversing out of net profit to approach accurate cash flow figures.

Understanding Cash Flow Adjustments

Depreciation and Amortization Adjustments

• The discussion begins with the need to adjust for depreciation, specifically noting a depreciation amount of $23,000 that must be added back into calculations.

Working Capital Movements

Current Assets Analysis

• The focus shifts to current assets, identifying cash, accounts receivable, and inventory. Non-current assets like equipment are excluded from cash flow considerations.

Inventory Changes

• An increase in inventory is calculated: closing balance of $94 minus opening balance of $68 results in an increase of $26. This increase is treated as a deduction in cash flow calculations due to cash spent on goods.

Accounts Receivable Changes

• Accounts receivable shows a closing balance of $120 and an opening balance of $98, leading to an increase of $22. This also requires a deduction from net profit since it indicates less cash recovery from customers.

Current Liabilities Movement

Liability Review

• A review reveals current liabilities including accounts payable and salaries payable; long-term borrowings are excluded as they pertain to financing activities.

Payables Increase Calculation

• The total closing balances for current liabilities sum up to $156 against an opening balance of $131, resulting in an increase in payables by $25,000. This amount is added back into net profit calculations as it reflects retained cash within the business.

Final Cash Flow Calculation

• After completing all adjustments (depreciation, inventory changes, accounts receivable changes, and payables), the net cash inflow from operating activities totals $70,000 using the indirect method.

Comparison Between Methods

Indirect vs Direct Method Insights

• Both methods yield the same result ($70,000), but the indirect method is quicker and preferred by larger companies using accrual accounting due to efficiency.

Presentation Differences

• The direct method offers a more intuitive layout resembling a cash basis income statement which aids investors in understanding financial flows better compared to the indirect method's less straightforward presentation.

Conclusion & Further Learning Resources

• While this video focuses on operating activities' cash flow adjustments only, viewers are encouraged to explore additional resources regarding investing and financing activities through linked videos provided at the end.