Cash flow statement indirect method: Definition and steps
- What is a cash flow statement?
- What is the cash flow statement indirect method?
- How to prepare a cash flow statement using the indirect method
- Direct vs. indirect method: Key differences
- Limitations of the indirect method
- Common mistakes to avoid
- Streamline your accounting with Ramp
Strong cash flow management is essential to your company’s financial health. It keeps operations running smoothly and supports long-term growth.
If you’re looking to simplify your financial reporting and gain clearer insight into how cash moves through your business, the cash flow statement indirect method can help. This approach bridges the gap between net income and actual cash movement, showing how profits translate into liquidity. It also helps you identify how non-cash transactions and working capital changes affect your bottom line.
What is a cash flow statement?
A cash flow statement is one of the three core financial statements businesses use, alongside the income statement and balance sheet. It tracks how cash enters and leaves your company through operating, investing, and financing activities, helping you see where money is being generated and where it’s going out.
Unlike the income statement, which measures profit, the cash flow statement focuses purely on cash movement. This makes it one of the clearest ways to gauge your business’s short-term health and ability to meet obligations.
What is the cash flow statement indirect method?
The indirect method of preparing a cash flow statement begins with net income and adjusts for non-cash expenses such as depreciation and amortization. It also accounts for changes in working capital accounts, including accounts receivable (AR), inventory, and accounts payable (AP).
This approach converts net income into cash flow from operating activities, linking profitability to real-world liquidity. Unlike the direct method, which lists every cash inflow and outflow, the indirect method focuses on reconciling net income with cash flow from operations.
In practice, it shows how profits translate into cash by reflecting the impact of non-cash transactions and balance-sheet movements. The indirect method also connects the income statement and cash flow statement, making it easier to assess overall financial health.
Why companies choose the indirect method
Most businesses rely on the indirect method because it’s efficient, widely accepted, and easier to prepare from existing records.
- Aligns with accrual accounting: Links net income and cash flow for a complete financial picture
- Simplifies preparation: Uses data from existing financial statements
- Reduces transaction tracking: Eliminates the need to record every cash movement individually
- Complies with global standards: Accepted under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS)
- Highlights cash generation efficiency: Shows how effectively net income turns into available cash
How to prepare a cash flow statement using the indirect method
Creating a cash flow statement with the indirect method involves adjusting net income for non-cash transactions and changes in working capital to show cash generated from operations. Follow these steps:
1. Start with net income
Begin with the net income figure from your income statement. This number appears on the final line and represents profit after all revenues and expenses for the period.
2. Adjust for non-cash expenses
Adjust for non-cash expenses:
- Depreciation and amortization: Reduce net income but don’t impact cash
- Other non-cash items: Include impairment charges, stock-based compensation, deferred tax expense, or bad-debt provisions.
Adding these back aligns net income with true cash movement.
3. Adjust for changes in working capital
Account for changes in current assets and liabilities to match net income with actual cash effects:
| Account | When to subtract | When to add | Explanation |
|---|---|---|---|
| Accounts receivable | When receivables increase (more sales on credit) | When receivables decrease (cash collected) | Growth in receivables ties up cash. |
| Inventory | When inventory increases (cash spent on stock) | When inventory decreases (cash released through sales) | Inventory growth consumes cash; reductions free it. |
| Accounts payable | When payables decrease (suppliers paid) | When payables increase (payments deferred) | Higher payables delay outflows and boost cash. |
4. Calculate cash flow from operating activities
Add the adjustments to net income to determine cash flow from operating activities, the amount of cash generated (or used) by your core business.
Example
- Net income: $150,000
- Depreciation: $25,000
- Increase in accounts receivable: $10,000
- Decrease in inventory: $15,000
- Increase in accounts payable: $5,000
Calculation:
$150,000 + $25,000 – $10,000 + $15,000 + $5,000 = $185,000
This means your company generated $185,000 in cash from operating activities.
5. Include cash flows from investing and financing activities
After operating cash flow, factor in other activities to capture total movement of cash.
Investing activities
Track cash used for or generated by long-term assets such as equipment or investments.
- Cash outflows: Purchases of property or securities
- Cash inflows: Proceeds from asset sales
Example: $50,000 spent on new equipment and $5,000 received from selling a vehicle equals –$45,000 in investing cash flow.
Calculate cash flows from financing activities
Show how your company raises or repays capital.
- Cash inflows: Issuing shares or taking loans
- Cash outflows: Repaying debt, paying dividends, or repurchasing shares
For example: $30,000 from new stock issued and $20,000 in loan repayments equals $10,000 in financing cash flow.
6. Finalize the cash flow statement
Combine all three sections to find total cash change:
Net Change In Cash = Operating + Investing + Financing
Using the examples above:
$185,000 – $45,000 + $10,000 = $150,000
If beginning cash was $50,000, ending cash equals $200,000.
Here's an example summary:
| Section | Cash inflows/outflows | Total |
|---|---|---|
| Operating activities | $185,000 | |
| Investing activities | –$45,000 | |
| Financing activities | +$10,000 | |
| Net change in cash | $150,000 | |
| Beginning cash balance | $50,000 | |
| Ending cash balance | $200,000 |
7. Review the cash flow statement
Cross-check totals against your income statement and balance sheet to confirm accuracy.
- Operating activities: Positive cash flow signals strong operations.
- Investing activities: Negative cash flow often reflects reinvestment for growth.
- Financing activities: Review capital movements to understand your funding strategy.
Regularly reviewing these results helps you spot trends, plan investments, and strengthen liquidity.
Avoid reconciliation errors
Verify that your ending cash balance matches the balance sheet figure. This simple check prevents reconciliation errors.
Direct vs. indirect method: Key differences
Both the direct and indirect methods can be used to prepare a cash flow statement, and each arrives at the same total for cash flow from operating activities. The difference lies in how information is presented and the level of detail involved.
| Category | Direct method | Indirect method |
|---|---|---|
| Approach | Lists all cash inflows and outflows from operating activities, such as cash received from customers and cash paid to suppliers. | Starts with net income and adjusts for non-cash items and working capital changes to calculate operating cash flow. |
| Clarity | Provides a clearer picture of actual cash transactions. | Shows how net income converts into cash and aligns naturally with accrual-based statements. |
| Preparation effort | More time-consuming; requires detailed cash transaction data. | Easier to prepare using information from the income statement and balance sheet. |
| Common use | Preferred by the Financial Accounting Standards Board (FASB) for transparency but less commonly used in practice. | Widely used by businesses because it’s simpler and accepted under both GAAP and IFRS. |
| Reporting standards | Both GAAP and IFRS permit either method. | Most companies choose the indirect method for efficiency. |
You might use the direct method when you want detailed visibility into cash receipts and payments, such as in investor reporting or educational settings. The indirect method is the default for business reporting because it’s efficient, aligns with accrual accounting, and meets GAAP and IFRS standards.
Conversion between methods
Both methods ultimately produce the same total for cash flow from operating activities.
- The direct method builds this total from detailed cash transactions.
- The indirect method starts with net income and adjusts to reach the same result
Reconciling the two simply involves matching the indirect method’s adjusted net income to the direct method’s itemized inflows and outflows.
Conversion between methods
Both methods ultimately produce the same total for cash flow from operating activities. The difference is in presentation:
- The direct method starts with cash transactions and builds up to net cash flow
- The indirect method starts with net income and adjusts to reach the same result
To convert between methods, you simply reconcile the net income figure from the indirect method with the detailed cash inflows and outflows used in the direct method. This ensures consistency across reporting formats and confirms the accuracy of your operating cash flow calculations.
Limitations of the indirect method
While the indirect method is efficient and widely accepted, it has a few limitations to keep in mind. Because it relies on summarized data and multiple adjustments, it can be harder to interpret and verify than the direct method.
Potential misinterpretations
The indirect method can confuse readers who aren’t familiar with accounting principles. Interpreting the various adjustments to net income takes a solid understanding of accrual accounting.
Complexities in adjustments
Adjusting net income requires precision. Small data errors or omissions in non-cash items or working capital accounts can distort reported cash flow and create inconsistencies across your financial statements.
Comparability issues
Because the indirect method summarizes cash activity rather than listing every transaction, it can make cross-company comparisons difficult—especially when one company uses the direct method and another uses the indirect approach.
Common mistakes to avoid
Even experienced teams can make errors when preparing a cash flow statement using the indirect method. Watch for these common pitfalls:
- Misclassifying activities: Placing investing or financing transactions in the operating section can distort operating cash flow
- Omitting key adjustments: Forgetting to add back non-cash expenses (like depreciation or amortization) or missing changes in working capital
- Double-counting items: Adding both a summary adjustment and the detailed line item separately
- Inconsistent sign conventions: Mixing up inflows and outflows (positive vs. negative amounts) when combining sections
- Not verifying totals: Failing to match the ending cash balance with the balance-sheet figure for the same period
To keep statements accurate, cross-check each adjustment against your income statement and balance sheet, confirm that the ending cash balance matches, and use automation or templates to reduce manual errors.
Streamline your accounting with Ramp
Preparing accurate cash flow statements doesn’t have to mean hours of manual work. Ramp’s accounting automation software streamlines every step, from automatically collecting receipts and categorizing transactions to syncing data directly with your accounting system in real time.
By reducing manual data entry and human error, we help you close the books faster, maintain accurate records, and gain instant visibility into cash flow.
Ready to get started? Explore a free interactive demo.
FAQs
Most companies use the indirect method because it’s faster to prepare and relies on data already available from the income statement and balance sheet. It also simplifies reconciliation between net income and cash flow, which helps teams manage monthly reporting.
Depreciation is a non-cash expense that reduces net income but doesn’t affect actual cash. Under the indirect method, it’s added back to net income to show the cash generated from operating activities.
Yes. Both GAAP and IFRS permit either method, though most companies prefer the indirect approach for its efficiency and simplicity.
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