How does the indirect method work?

Definition

The indirect method builds cash from operations by starting at net income and then adjusting for items that were not cash. On the books, this is how most small-business packs assemble the top section of the Statement of Cash Flows, not a ledger account you debit.

A pediatric clinic reads it as a bridge. The leftover on the Income Statement is the start; depreciation and working-capital moves are the steps to cash.

It is a presentation, not a second set of books. The same month's visits, wages, and supplies sit underneath; only the path to cash is restated.

Accrual leftover includes visits billed and costs incurred, even if cash has not moved. This method puts those timing gaps back into view.

Where it shows up

Cash flow: Related to how the operating section is built.

P&L: Related to net income, the starting number.

Balance Sheet: Related to the working-capital changes in the bridge.

See also: Cash Flow From Operations · Net Income · Changes In Working Capital

When you look at your Statement of Cash Flows, the operating section often starts at leftover profit. Depreciation expense is added back; movements in accounts receivable and accounts payable come next.

When the bridge is close to leftover profit, collections and payables did not move much. When it is far away, the clinic billed visits it has not collected, or it paid or delayed supplier bills.

The Balance Sheet supplies the changes. You compare this month's receivable, inventory, and payable balances to last month's.

The Income Statement supplies the starting leftover. This method does not replace that leftover; it explains why cash differed.

A high leftover with a weak operating-cash figure usually means collections lagged. A modest leftover with strong operating cash can mean payables grew or receivables came in.

The investing and financing sections sit below this operating block. This method is only about how the operating block is built.

How it works

Start with this period's net income. That leftover already includes visits earned and costs incurred.

Add back non-cash expenses. Depreciation on exam-room equipment is the usual add-back, because it reduced profit without writing a check.

Adjust for working-capital changes. If receivables rose, the clinic earned visits it has not collected, so cash is lower than leftover.

If payables rose, the clinic held onto cash by taking longer to pay vendors. That change is a source of cash in the bridge.

If supplies on the shelf rose, cash went out to stock them. That change is a use of cash.

Stay with the bridge when you read the section. Do not rebuild the month as a list of checks written.

Do not treat the add-back as cash the clinic received. Adding depreciation back only undoes a non-cash charge.

After the month closes, this bridge is the period's path from leftover to operating cash. Next month starts again from that month's leftover and that month's Balance Sheet changes.

Operating income is leftover from core work before interest and tax. The bridge usually starts further down, at the full leftover after those items.

Inventory swings belong in the same working-capital block when the clinic stocks vaccines or supplies. A rise uses cash; a fall frees it.

Example

Maple Street Pediatrics posts $12,000 of net income this month. Depreciation on exam-room equipment is $2,000.

Accounts payable rose $1,500, and accounts receivable rose $4,000. Add depreciation and the payable increase, subtract the receivable increase, and operating cash is $11,500.

The $11,500 is the cash from running the clinic this month. It is not the $12,000 leftover, and it is not the bank's ending balance.

If the same month had no receivable increase, operating cash would be $15,500. The leftover would still be $12,000.

A busy week of well-child visits that have not been paid will raise leftover and raise receivables together. The bridge takes that unpaid slice out of cash.

Last quarter the clinic posted $10,000 of leftover and $9,000 of operating cash. This month's $11,500 is a closer bridge because payables helped.

Common mix-ups

The indirect method is not the same as net income. Net income is the starting leftover; this method adjusts that leftover to cash.

The indirect method is not the same as the direct method. The direct method lists cash receipts and payments; this method starts at leftover and adjusts.

The indirect method is not the same as the bank balance. The bank balance is a snapshot; this method explains operating cash for the period.

Related terms

• Cash Flow From Operations: Cash generated or used by the day-to-day running of the business.
• Net Income: What is left from revenue after every expense, including interest and taxes, is subtracted.
• Non-Cash Expenses: Charges that reduce profit without moving cash.
• Changes In Working Capital: The cash effect of movements in receivables, inventory, and payables.
• Statement Of Cash Flows: A statement that explains how cash moved through operating, investing, and financing activities during a period.
• Direct Method: Building operating cash flow by listing actual cash receipts and payments.
• Depreciation Expense: The periodic charge that spreads a fixed asset's cost over its useful life.
• Adjusting Journal Entry: An entry made at period end to record accruals, deferrals, and corrections.