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Indirect Method Summary

Brian Krogol
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Alright, now let's learn how to calculate our operating cash flows using the indirect method. So there's two methods for calculating operating cash flows. We've got the indirect method and guess what? The direct method. So most companies use the indirect method and most professors just focus on the indirect method. A lot of textbooks teach both of them, but sometimes professors will just overlook the direct method and focus specifically on the indirect method. So double check if you're gonna need to know the direct method before you spend some time with it, but definitely you're gonna need to know the indirect method. So let's start with that one here. So the indirect method, it starts with net income and it it indirectly gets us the operating cash flows. That's why it's called the indirect method. So, I want to make one note here that regardless of whether using the indirect or direct method, you're only calculating your operating cash flows when you do investing activities and financing activities. Well, those are their own beast. Regardless of the indirect or direct method. They have nothing to do with those methods. Okay. They're gonna always be calculated the same way. Regardless of if you use the indirect or direct method, the financing and investing activities are separate. Okay, so indirect method, what I have here on this first page of this of this unit is kind of a cheat sheet that I want to fill out with you and then you can use it as you go through your practice problems and your examples and your homework, you can use this to help you kind of guide you through your through the calculation. Okay. So remember the indirect method, it's called the indirect method because we start with net income and we adjust it to indirectly find our operating cash flows. O. Cf is operating cash flows. Okay? So let's go through the steps that we're gonna go through in the indirect method. We're gonna start here with net income and net income is found on the income statement, right? You guys are ready with that by now. You guys know that you're gonna find net income on the income statement and that's our bottom line there and then we're gonna adjust that net income based on different factors to arrive at our operating cash flows. So the first thing we want to know is that in net income there's things that are not cash that are affecting our net income number. Okay. So what we wanna do is we want to get rid of those non cash effects. The first non cash effect is non cash expenses. Okay, So that's the first thing we're gonna do is we're gonna get rid of the effect of non cash expenses. So we're gonna add those back. If you think about it and expense reduces income, right? If we take an expense, well, that's going to reduce our net income. So if we're gonna have a non cash expense, we want to get rid of that effect in net income because we're only focused on cash activities when we're talking about the cash flows. So the most common non cash expense. Can you think of what it is? We've talked about it before in this course are most common. Non cash expense is depreciation expense. So when we talk about depreciation or amortization, think about depreciation expense, we had some machinery or some building that we bought, right? And we bought it upfront. We paid a big cash amount up front and then over its useful life. We depreciate it. But when we take that depreciation, it's not like we're paying out cash to depreciate the building. No, it just represents the wear and tear on the building, right? It's not an actual cash outflow when we take depreciation expense. So we want to get rid of that effect because that depreciation expense had reduced our net income. Well, we want to get rid of that effect. So we're gonna add it back in, right? We're gonna add back the depreciation expense as if it had never happened. Okay, so we're gonna add that back because we're focused on cash flows, right? So the next non cash activity in net income is gains and losses. So, if you think about when we sell a a plant asset, maybe we sell a piece of equipment? Well, there is a cash flow involved there, right? We're gonna receive some cash for selling it. But the gain or the loss on the sale is the difference between that cash flow and the book value, right? That gain itself is not a cash amount. So that's going to be affecting our net income because gains and losses they do go into our income statement and they do affect our net income, but they're not a cash amount. So we want to get rid of their effects. Now, you have to think about each effect separately, right again and a loss are going to be opposites here. So let's start here with gains. When you think about it, you're gonna have to think about it in a logical order. So, first, you're gonna think, okay again, had originally increased that income, right gains, increase our net income, but like I said, they're not a cash amount. So we need to get rid of their effect. So we remove the effect of the gain, we must reduce the net income amount by that gain as if it had never happened. Okay, so remember, this is all focused on finding our operating cash flow. We start with net income, which should be a number close to our operating cash flow. And we're adjusting it for all of these different items that shouldn't that wouldn't be cash effect. So we would deal with gains in that way. And the next we have losses, losses are going to be the opposite losses, decrease our net income. So to get rid of their effect, we must increase our net income, right? We must remove the effect of the loss by increasing our net income by the amount of the loss. Okay, so we're gonna see all of these things in an example and it'll make a lot more sense once we get there. But this sheet is going to be very important when you're studying and you're doing your practice problems to solve the operating cash flow. So there we go. We've gotten rid of the non cash effects in net income. The next thing we need to do is we need to deal with our changes in our current assets except for cash and our changes in current liabilities. So the idea here is if there's an increase in a current asset, let's say at the beginning of the year you had $100,000 in inventory and at the end of the year you have $120,000 in inventory. Well how could we have increased our inventory? We had to pay cash. Right. So the idea here is if there's an increase to a current asset that means there was a decrease to cash. Okay, we'll go into more details about this. But that's the best way that's the way I always think about it. I always think of a current asset, I always related to inventory because that's what makes the most sense in my head, right. The only way we could have increased our inventory balance throughout the year was to have paid out more cash to increase that inventory. So now it's almost like some of our cash balance is tied up in our inventory during during the year. So we have less cash on hand, right? We've decreased our cash to increase our inventory. And it's the opposite. What if we decreased our inventory? Well that means we've loosened up some of our cash that was tied up in the warehouse. Well now it's not tied up anymore, so we have more cash available. Okay. So this is important because we're going to be looking at our balance sheet from year to year and we're gonna see the change in each current asset and each current liability and that's going to be a part of our calculation of our operating cash flow. Okay, So that's gonna be very important and it's the opposite for current liabilities. Okay. So it's the same idea if we had an increase in a current liability. Well this is actually an increase to cash. So the idea here, I like to think about accounts payable, let's say we had $100,000 in accounts payable last year and now this year's balance is $120,000. Well that means we've loosened up some cash right? Because we're able to OR suppliers more money. Well we're able to have more money available because we're saying oh we'll pay you guys later, don't worry about it and we've got more cash available now because we're paying them later. So an increase to a current liability is an increase to cash. And the opposite a decrease to a current is a decrease to cash, right? Because let's say we had owed 100,000 last year and now we only owe 80,000. Well, how could we have decreased that balance in accounts payable by paying out cash? Right? We would have lost some cash to decrease that balance. Okay, So we're gonna see in an example how to deal with this uh in more details, but this should be a cheat sheet. Just like I said, you're gonna use this. This should be very handy when you're calculating the indirect method. Okay, So remember once we've gone through all of those things, we are calculating our net cash inflow or outflow if it's negative from operating activities. Okay, so all of this, everything we just went to went through is just to calculate the net cash flow from operating activities. Okay? We're gonna have a different lesson for investing activities, financing activities, as well as how to do the direct method if you guys need to know that. Okay, so now that we know the steps, let's go through an in depth example to see how this all works. Let's do it in the next video