Cash Flow Statement: Indirect Method
Practice preparing the operating section of the cash flow statement using the indirect method. Start with net income and adjust for non-cash items and changes in working capital.
Problem Scenario
Golf Corp reports net income of $75,000 for Year 1. Additional information: Depreciation Expense $18,000; Accounts Receivable increased $12,000; Inventory decreased $5,000; Prepaid Expenses increased $2,000; Accounts Payable increased $8,000; Accrued Liabilities decreased $3,000; Gain on Sale of Equipment $4,000.
Given Data
Requirements
- Start with net income
- Add back non-cash expenses (depreciation)
- Remove gains/losses from operating section
- Adjust for changes in current assets
- Adjust for changes in current liabilities
- Calculate net cash from operating activities
Solution
Step 1:
Start with Net Income: $75,000. This is the starting point for the indirect method.
Step 2:
Add back Depreciation Expense: +$18,000. Depreciation reduced net income but did not use cash. Adding it back removes this non-cash charge.
Step 3:
Subtract Gain on Sale of Equipment: -$4,000. The gain increased net income but is not an operating activity (it belongs in the investing section). Remove it from operating cash flow.
Step 4:
Adjust for changes in current assets: Increase in AR: -$12,000 (sold on credit but didn't collect cash). Decrease in Inventory: +$5,000 (sold more inventory than purchased). Increase in Prepaid: -$2,000 (paid cash for future expenses).
Step 5:
Adjust for changes in current liabilities: Increase in AP: +$8,000 (received goods but didn't pay cash yet). Decrease in Accrued Liabilities: -$3,000 (paid cash for previously accrued expenses).
Step 6:
Calculate total: $75,000 + $18,000 - $4,000 - $12,000 + $5,000 - $2,000 + $8,000 - $3,000 = $85,000
Final Answer
Net Cash from Operating Activities: $85,000. The company generated $10,000 more cash from operations than its net income suggests, primarily due to depreciation being a non-cash expense.
Key Takeaways
- ✓The indirect method starts with net income and adjusts for non-cash items
- ✓Depreciation is added back because it reduced income but used no cash
- ✓Gains on asset sales are subtracted (they go in the investing section)
- ✓Increases in current assets use cash (subtract); decreases free up cash (add)
- ✓Increases in current liabilities provide cash (add); decreases use cash (subtract)
Common Errors to Avoid
- ✗Subtracting depreciation instead of adding it back
- ✗Getting the direction wrong for working capital changes (increase in AR means LESS cash, not more)
- ✗Including the gain on sale of equipment in operating activities instead of investing
- ✗Forgetting that decreases in current assets free up cash (they should be added)
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Common questions about this problem type
Depreciation reduced net income (it's an expense on the income statement) but it did not require any cash outflow. The cash was spent when the asset was originally purchased. Adding it back converts from accrual income to cash-basis.
An increase in AR means the company recorded revenue (increasing net income) but didn't collect the cash yet. To convert from accrual to cash, we subtract this amount because income was recognized without corresponding cash inflow.