Under the indirect method cash flow statement, operating cash flow is calculated by reconciling net income to cash flow.
The reconciliation involves (a) adding back to net income any noncash expenses, such as depreciation and amortization, and (b) adding or subtracting changes in operating working capital accounts on the balance sheet.
An increase in a current asset represents a use of cash and is subtracted from net income. For example, an increase in accounts receivable means that the company’s recorded sales are greater than payments received from customers. Similarly, an increase in inventory means the company’s inventory purchases in the period are greater than cost of goods sold. In both cases, an increase in these accounts represents a use of cash. Conversely, a decrease in a current asset is a source of cash. For example, a decrease in accounts receivable means that the company’s recorded sales are less than payments received from customers.
An increase in a current liability account represents a source of cash and must be added to net income. For example, an increase in accounts payable means that the company’s purchases of operating inputs are greater than payments made to suppliers. Conversely, an increase in a current liability represents a use of cash. For example, a decrease in accounts payable means the company’s purchases of operating inputs are less than payments made to suppliers.
The indirect method cash flow statement only differs from the direct method cash flow statement in the operating cash flow section. The indirect method is the most widely used method for calculating operating cash flows.
