Cash flow statement: the indirect method

The indirect method starts with profit and removes everything that isn't an operating cash flow. It is the method most companies use, because every figure comes straight from the income statement and two balance sheets. IAS 7 permits the direct or the indirect method for operating activities (it encourages the direct method, covered in the next lesson); US GAAP allows both too.

The four steps 1. Start with profit — profit for the period, or profit before tax (then interest and tax are adjusted out and shown as separate cash lines). 2. Add back non-cash expenses and deduct non-cash income: depreciation, amortisation, impairment losses, unrealised fair value changes, increases in provisions. 3. Remove investing and financing items that sit in profit: deduct a gain on selling equipment and add back a loss, because the full sale proceeds are reported in investing activities. Leaving the gain in would count part of the proceeds twice. 4. Adjust for operating working capital: subtract increases in receivables, inventory and prepayments; add increases in payables, accruals and deferred income — and the reverse for decreases.

Only operating balances. Working-capital adjustments cover the balances created by trading. Movements in dividends payable, loans, payables for equipment purchases or share capital are financing or investing items and are left out of operating activities. If you start from profit for the period, the movement in income tax payable is a working-capital adjustment; if you start from profit before tax, add back finance costs and deduct the tax and interest actually paid instead — both formats give the same total.

Checking your work. The operating total plus investing and financing must equal the change in cash on the balance sheet. If it doesn't, a balance movement has been missed or given the wrong sign.