What is so compelling about the cash flow indirect method ?
The cash flow indirect method uses the information from the cash statement to calculate the cash flow within a certain period. It is used both by companies for quick calculations and by investors who want to get an idea of the financial situation of a company. We show you here how this method works and demonstrate it with an example.
The cash flow indirect method is a way to calculate a company's cash flow from the data on the cash statement. It is called the indirect method because the cash flows are not used directly for the calculation, but are determined from the turnover.
On the cash statement, the income and expenses during a certain period are summarised in categories. These are divided into the following areas:
- Operating activities: All activities related to the production and distribution of a product.
- Investing activities: activities in which assets were acquired or sold
- Financing activities: activities in which shares were issued or dividends distributed
In the indirect method, all activities that are not cash-based are deducted from the turnover. The result is therefore exactly the cash flow that was generated within the period under consideration. The calculation is done step by step.
First, one calculates the operating cash flow:
Operating cash flow = Net income + depreciation and amortisation + accounts receivables + inventory + accounts payables
The investing cash flow is all cash that has flowed within the scope of investment activities and can also be found in the cash statement:
Investing cash flow = Incoming investment cash flows - outgoing investment cash flows
Just as with the investing cash flow, the financing cash flow is determined from the cash statement:
Financing cash flow = Incoming financing cash flows - outgoing financing cash flows
Now add up the individual cash flows:
Net change in cash balance = Operating cash flow + investing cash flow + financing cash flow
This result represents the cash flow at the end of the period under consideration and must now be offset against the initial value:
Cash balance at end of period = Net change in cash balance + cash balance at start of period
Let's take a closer look at the formulas from the above section with an example. A company has the following item on its cash statement:
Net income: £100,000 Depreciation: £10,000 Inventory: -£30,000 Accounts receivable: £60,000 Accounts payables: -£20,000 Investing cash flow: -£40,000 Financing cash flow: £5,000 Cash balance at start of period: £50,000
We are now calculating:
Operating cash flow = Net income + depreciation and amortisation + accounts receivables + inventory + accounts payables = £100,000 + £10,000 - £60,000 + £30,000 - £20,0000 = £60,000
Net change in cash balance = Operating cash flow + investing cash flow + financing cash flow = £60,000 - £40,000 + £5,000 = £105,000
Cash balance at end of period = Net change in cash balance + cash balance at start of period = £105,000 + £50,000 = £155,000
As we have seen in the example, the starting point for calculating the cash flow with the indirect method is the turnover. All non-cash activities are then deducted from this.
In the direct method, on the other hand, the cash flow is calculated directly from the individual cash flows. This means that all income is compared with the expenditure for the period under consideration. To do this, it is necessary to look at the account transactions, because these represent the incoming and outgoing cash flows. These include, for example:
- Salary payments to employees
- Payments to suppliers
- Customer payments
- Cash income from sales
- Fees for software licences
The direct method is more accurate than the indirect method because it includes the actual cash flows in the calculation. However, it is more time-consuming unless appropriate cash flow management software is used.
The cash flow indirect method provides a result more quickly and can also be used by people who have no insight into the company's business accounts, e.g. investors.