Indirect Method

What Is the Indirect Method in Accounting?

The indirect method is a standard accounting technique to reconcile net income (from the income statement) to the cash provided by or used in operating activities on a cash flow statement. This method starts with net income and then adjusts for non-cash expenses, non-operating items, and changes in working capital. 

By breaking down these adjustments, analysts and investors gain a clearer understanding of the sources and uses of operating cash flow and can better assess the quality of earnings, liquidity, and operational efficiency. 

Understanding the Indirect Method

Income statements are prepared using accrual accounting, which includes non-cash items and accounting-related timing differences. Therefore, net income does not reflect actual cash generated by the business. Under the indirect method, you can adjust net income for those non-cash expenses and timing differences to determine actual cash flow for the period.

Non-cash expenses are items that affect net income but do not involve actual cash movement. These items are added back (for expenses) or subtracted (for gains) to reconcile net income to cash flow from operating activities. 

Common non-cash adjustments include:

1. Non-Cash Expenses

Items that reduced net income but did not use cash:

• Depreciation: Expense recorded for the reduction in value of assets, but no cash goes out.
• Amortization: Similar to depreciation, but for intangible assets.
• Stock-based compensation: Expense related to employee compensation paid in shares and is not a cash outflow.
• Asset write-downs: Non-cash expense due to reduction in asset value.
• Deferred taxes: Tax expenses recognized in accounting but not yet paid in cash.

2. Non-Operating Items

Gains and losses from financing or investing, such as a gain from the sale of an asset, which do not reflect actual cash related to operations:

• Losses on asset sales: Losses recorded on the income statement, but the cash effect is part of investing activities.
• Unrealized gains or losses: Unrealized gains and losses do not involve actual cash receipts or payments, so they must be subtracted (for gains) or added back (for losses).

3. Changes in Working Capital

Increases or decreases to current assets and liabilities:

• Accounts receivable (current asset)
• Inventory (current asset)
• Accounts payable (current liability)

Indirect Method Example

This example mirrors the process seen in real-world financial statements and models. 

Start by gathering the relevant figures from the income statement and balance sheet. You’ll use these figures to perform the calculation in the table below.

• Net income: $10 million
• Depreciation expense: $2 million
• Amortization expense: $500,000
• Accounts receivables (AR): Increase by $3 million
• Inventory: Increase by $1.5 million
• Accounts payable (AP): Increase by $2.2 million
• Other current liabilities: Decrease by $700,000

Step-by-Step Calculation

Explanation:

• Start with net income at the top.
• Add back non-cash expenses (depreciation and amortization).
• Subtract increases in current assets (uses of cash).
• Add increases in current liabilities (sources of cash).
• Subtract decreases in current liabilities (uses of cash).

Result: Net cash provided by operating activities = $9.5 million. 

Interpretation

In this example, net cash from operations ($9.5 million) is $500,000 less than net income ($10 million). This difference occurs because the company invested cash in growing accounts receivable and inventory, which reduced available cash. 

Key Points:

• Net income and cash flow are different measures.
• Non-cash expenses affect net income but not cash generated by the business.
• Working capital movements can increase or reduce cash flow.

Indirect vs. Direct Method: What’s the Difference?

The indirect method starts with net income and adjusts for non-cash items and working capital changes. The direct method lists actual cash receipts and payments from operations, such as cash collected from customers and cash paid to suppliers. 

Both methods arrive at the same cash flow from operating activities, but the indirect method is more commonly used because it’s easier to prepare from existing financial statements.

Indirect Method:

• Starts with net income and adjusts for non-cash items (like depreciation) and changes in working capital (accounts receivable, inventory, accounts payable, etc.).
• Most commonly used because it’s easier to prepare using existing financial statements.
• Helps reconcile accrual-based net income to actual cash flow.
• Example steps: Net Income + Non-Cash Expenses – Increase in Current Assets + Increase in Current Liabilities = Cash Flow from Operations.

Direct Method:

• Lists major classes of gross cash receipts and payments (e.g., cash collected from customers, cash paid to suppliers, cash paid for salaries).
• Shows actual cash inflows and outflows from operating activities.
• Less commonly used because it requires tracking cash transactions in detail, which can be more time-consuming.

Which method is better?

The indirect method is generally more common in practice because it is much easier and faster to prepare using information already available from the income statement and balance sheet. Most companies and accountants use the indirect method for this reason. 

The direct method provides more detailed information about specific cash receipts and payments, but it is less common due to the extra effort required to track and report each cash transaction. Both methods result in the same net cash from operating activities, so the choice is primarily about practicality and efficiency.

FAQs: Indirect Method

What is the indirect method of cash flow?

The indirect method is a standard accounting technique used in the Cash Flow Statement to reconcile net income (from the income statement) to the actual net cash provided by or used in operating activities. The indirect method links the accrual-based net income figure to the actual cash flow so accountants or analysts can reconcile financial statements.

What is the indirect method formula?

The indirect method formula begins with net income and adjusts for non-cash items and working capital changes to calculate cash flow from operating activities. You add back non-cash expenses, remove non-cash or non-operating gains, and add or subtract changes in working capital accounts to show the cash generated or used during the period.

Why is the indirect method more common than the direct method?

The indirect method is more common because the data is readily available from a company’s standard accrual-based income statement and balance sheet. The direct method, in contrast, requires tracking and aggregating every single cash transaction (e.g., cash paid to suppliers, cash received from customers), which is far more time-consuming and labor-intensive.

Additional Resources

Accrual Accounting

IFRS vs. US GAAP

Projecting Balance Sheet Line Items

Projecting Income Statement Line Items

See all Accounting resources