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Financial Accounting
Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.
13. Statement of Cash Flows
Operating Activities: Indirect Method
1
concept
Indirect Method Summary
8m
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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
2
example
Indirect Method (1)
6m
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Alright. So on this next page we have some financial information for the abc company. We've got comparative balance sheets showing last year's balance and this year's balance. This is going to be important for those changes in current liabilities and those changes in current assets. And then as we scroll down, we've also have our income statement, right? And this is important because we need our net income and we need to be able to find depreciation, expense and our gains and losses to calculate our operating cash flows. So if you go to your next page, you're gonna see that we have an example here. So this is gonna be our in depth example where we're going to calculate our cash flows from operating activities using the indirect method and we're gonna be using that balance sheet and the income statement from the previous page. Okay. So let's take it step by step. We're gonna be using the indirect method and notice what we've got here. This is going to be this section of the cash flow statement. So notice we're only focused on the operating activity section of the cash flow statement here. So we're gonna start with net income and then we're gonna make our adjustments based on the steps that I showed you on the first page and then we're gonna end up with our net cash provided or used by our operating activities. Okay? So let's go ahead and start with our net income. Where are we gonna find our net income. Well that comes from the income statement, right? And we'll go up to our abc company income statement And we'll find our net income right here. So step one right here, net income is $145,000. Step one is done. Alright. We're well on our way to finding our net income, our operating cash flows here. So we're gonna have $145,000 as our starting point for our net income. Okay? And now we need to start making each of our adjustments. So we started here with net income. Next we need to add back our non cash expenses. So what are the non cash expenses we're gonna mostly most often look for, it's gonna be depreciation expense or possibly amortization expense most of the time that's just gonna be depreciation or they're gonna be added together. They'll say depreciation and amortization. So we're gonna be looking for depreciation expense here because that's the only one that shows up on their on their income statement. Remember this comes from the income statement. So we're going to scroll back up to abc company's income statement and we're gonna look for those non cash expenses and notice how they gave it to us here. They told us all the operating expenses excluding depreciation and then they told us depreciation separately here, depreciation expense is $9000. Okay, So we need to add back the $9000 for depreciation expense. So we would have it here, we would have it listed depreciation expense And we would put it in $9,000. We're gonna make a separate column here for our our adjustments, whoops. Let me make that line up there, $9,000. Okay, so that's our depreciation expense and that came out to $9,000 here. Okay, now let's do our effects of gains and losses. Right? Step three. Now, before I go into the to the example above, I wanna give you guys a little more clarity on why we remove the effects of gains and losses. So assume we had sold equipment for $8000 and and had accumulated. Excuse me, It had cost us $8000 with accumulated depreciation of 1000 and we received $4000 in cash from the sale. So notice in this situation we would have made a journal entry for cash for $4000 Right? So 4000 would have been our our cash debit and we would have had to get rid of the accumulated depreciation and the cost of the equipment. So we would get rid of the accumulated depreciation with a debit for 1000 and we would get rid of the equipment with the credit, right? Because it had a debit balance on our book. And now we're getting rid of it with a credit. So that gets the equipment off of our books, it gets the accumulated depreciation off of our books. And with the cash that was involved in the transaction. Finally, to balance this entry, we either have a loss or a gain in this case, our credits are bigger than our debits. So we're gonna have a loss, right? So we would have a loss On sale. So we would have had a loss on the sale of the equipment for 3000. And that's what would balance out this equation, right? And this loss would go to the income statement. But notice that that loss is not the cash amount. The cash amount is this $4,000, but that $4,000 would be an investing activity, right? Because this deals with the sale of a long term asset. And as we discussed long-term assets are investing activities. So in this case this $3,000 loss on the income statement, it shouldn't be part of our operating activities. It had reduced our net income, but we need to get rid of that effect. Okay, so that's why we removed the effects of gains or losses. It would have been the same thing if we had a gain that would have affected our net income. But it wouldn't be the cash amount. The cash amount in these transactions should be investing activities. And we don't need those gains to be inside of our our operating activity calculation. So let's go back up into our income statement and let's see if there are any gains or losses to get rid of here. So right here, we have number three, our loss on disposal of plan assets, it's going to be this 3000 right here. Just like in our example, we have a $3,000 loss uh, from the disposal of plant assets. So we need to get that out of our net income. So what do we need to do? We need to add back the loss, right. The loss had decreased loss on sale of plant assets. We need to increase our net income by that amount, which was 3000. So these are increases, right? We needed to add back depreciation. We needed to add back the loss on the sale of plan assets. And then that's all we need to do with the income statement. At this point, we've we've done the the expenses and the gains or losses. Why don't we pause here and we'll finish up this example by dealing with the changes in current assets and the changes in current liabilities. Cool, let's do that in the next video
3
example
Indirect Method (2)
4m
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Alright now let's continue our example with the changes in current assets other than cash and the changes in current liabilities. So this is going to come from the balance sheet and remember a change in a current asset. Well if we have an increase in a current asset it's a decrease the cash, it's going to be an opposite. So a lot of times this can be confusing, especially when you get to a test and everything is very time crunch. So the way I like to think about this is to think assets equal opposites. Alright, it's kind of silly and it's kinda misspelled but it's the way I like to think of it as a kind of a silly way to remember this thing. The assets are opposites when we come to our income statement. Excuse me. Our cash flow statement. So what does that mean increase in current asset is a decrease to cash. Okay so this is something silly I made up to help me remember this um and I hope it helps you to assets are opposites when it comes to this stuff. Okay so the reason this makes it should make sense is if our if our inventory balance let's say let's look at inventory as an example here. So if inventory let's say had started at 100,000 and at the end of the year it was 100 and 20,000. That means we had net purchases during the year. It should have increased by 20,000 during the year. So how could it have increased by 20,000, That would be by buying more inventory. Right so we would debit inventory for 20,000 and credit cash for 20,000. Okay so this is a simple example but notice cash is decreasing when inventory is increasing. Okay. So yes there's more things that go into an inventory calculation like cogs. Um Other other effects can go into inventory. But if there's a net increase to inventory you can assume that we've increased our our commitment to inventory by putting more cash into inventory. Okay so that's exactly what's going on here is we're investing more of our cash into this inventory. So we have less cash available, we're decreasing our cash there. Okay And and so if you remember that the assets are the opposites right? Where we've got the increase in current assets is a decrease in cash or a decrease in current assets is an increase to cash. Their opposites. Well changes in current liabilities there. Just the other one. Okay. As long as you remember that the assets are opposites. The current liabilities is just going to be the other one where an increase to a current liability, current liability gonna put liability is a increase to cash. Okay so those go hand in hand, they're not opposites, they go increase and increase where with an asset it was increase and decrease. Right? So let me show you in an example here, just like with inventory, let's say it was accounts payable. Now we're talking about a current asset accounts payable where we had, let's say a 100,000 starting balance in accounts payable and the accounts payable. Let's say in this case went down well, we'll do an increase as well. 100 and 20,000. Okay. So how did how do we uh increase? Well, this actually makes more sense when we do a decrease, it's easier to understand. So let's say a decrease to 80,000. Right? We had 100,000 in accounts payable and it decreased to 80,000. So that means we would have had to have some debit To accounts payable to decrease it by this 20,000 balance. So how would we decrease our accounts payable by paying them off? Right? We have accounts payable. These are accounts that we owe money to our suppliers. We have these debts to pay out. Well, how do we get rid of those debts is to pay them? Right. So we would in this case debit accounts payable for those 20,000 that we had paid off? And we would credit cash because we paid them in cash. So notice we decrease our accounts payable and we decrease our cash. So they go hand in hand in this situation. Okay, so that's the best way to think of it. I like to just remember the assets are opposites and then boom. You can't forget it. Okay, so now let's go ahead. We'll pause here and in the next video we'll finish up the example using this logic. Alright, let's do that now.
4
example
Indirect Method (3)
7m
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Alright. So let's use this logic of our changes in current assets and changes in current liabilities to finish up our example. Alright, so let's go go ahead. And we're gonna go back to our page with our balance sheet on it. So what we're gonna do is we're gonna look for our changes our changes in current assets and liabilities. That's what's gonna go into this rest of this section to finally figure out what our operating cash flow is. Okay, so the best way to do this is to go to your comparative balance sheet. And in this example I have included an extra column here, change an account balance. Now your professor doesn't have to give this to you. They could just give you the two years, they could give you this year's number and last year's number and then you have to figure out the change in account balance. Sometimes they'll give you the change in account balance and you don't need to do this calculation at all. But we're gonna do it every step of the way here. Okay. So the first thing we need to know is whether each account increased or decreased and what the change in account balance was there. Okay. So notice in this problem, since we're only focused on operating cash flows, all we're going to calculate is the current assets and current liabilities. Okay. Sometimes it's necessary to find the changes in in the Um investing accounts and in the equity accounts as well. But we're only focused on current assets and current liabilities. So let's do that just to save time here and remember, we don't need to do cash. Cash is the point of the entire statement. Once we finish our entire statement operating investing financing, our cash should be showing it should show us the change in cash from the beginning balance of 33,000 To the ending balance of 55,000. Right? So what we're focused on and like we saw in our in our example, it says changes in current assets, accept cash and current liabilities. So let's check those out. Our accounts receivable last year was 30,000 and now it's 20,000. So it's decreased by 10,000. Okay. So I'm gonna put it in parentheses to signal that it was a decrease of 10,000 And our inventory. Well last year it was 21,000 and now it's 30,000. So our inventory has increased by 9000. Right? You see how I'm calculating this, we're just taking the difference between the two years and then we're gonna stay whether it's positive or negative using parentheses for negative numbers. Okay, so those are changes in current assets. Let's check out our changes in current liabilities. So we've got two here, we've got accounts payable and income taxes payable. So the first one is accounts payable last year it was 12,000. Now it's 28,000. So we've had an increase of 16,000 from one year to the next income taxes payable last year, they were 8000. Now there's 6000. So they've decreased by 2000. Right? So notice this goes with the explanation I just gave you right? Because now we know the increase or decrease in each account. And if we remember that the assets are the opposites and the liabilities, well there the other one that goes hand in hand. Well then we're just about done with our operating cash flows using the indirect method. Okay, so now we're gonna go one by one. Let's start with accounts receivable. And we saw that it was a decrease of 10,000. So since assets are opposites, we're gonna say a decrease in accounts receivable. Well that's an increase to cash, right? Because they're opposites. So the decrease of accounts receivable of 10,000 is an increase to cash of 10,000. Let's do the next one. The next one was inventory, right? We had an increase of inventory. So over here we had an increase of inventory of 9000. Well, an increase, this is an asset. The assets are opposites. So the increase in inventory. Well, that's gonna be a decrease to cash, right? And that's gonna be in the amount of 9000. So now we've decreased for for the inventory now let's go on to the next one. Right? So this is the process. We're gonna go one by one with our current assets and current liabilities. We were done with our current assets. Let's do our current liabilities here, we had accounts payable and Income taxes payable. So accounts payable. Remember these go hand in hand, right? The assets are opposites while the liabilities they go together. So an increase in accounts payable is an increase to cash in the amount of 16,000. So we'll go down here and we'll say increase In accounts payable. And that was in the amount 16,000. And that's going to be our increase there. Right? So that's an increase. They go hand in hand. And what about the other one? We had income taxes payable and we had a decrease, right? A decrease in an income tax payable which is a current liability is a decrease to our cash. So the 2000 is going to be a decrease to our cash here. And guess what will be done at that point? We just need to do our final calculation so decrease in. I'm just gonna put tax payable just to save time here. So the increase the decrease in the tax payable was a decrease of 2000 to our cash. Okay so first thing we're gonna do is add up all of our adjustments because this is generally how we would show it on a on a statement. So we'll do 9000 plus 3000 plus 10,000 minus 9000 plus 16,000 minus 2000. So we get a $27,000 change in cash during the period because of our operations. And excuse me because of those adjustments, those adjustments total 27,000 and that's what we're going to add to our net income. This could have been a positive number, it could have been a negative number. It just depends on what happened during the period. Right In this case we got adjustments that came out to a positive 27,000. We're gonna add that to our net income of 100 and 45,000 And it gets us to our final answer here. 172,000 is our our net cash provided from operations. Okay. So from our operating activities we had 100 and 72,000 in cash. That's from starting with net income and then doing our adjustments for non cash expenses, gains and losses and then changes in current assets and current liabilities. This is pretty tough. This is one of the tougher lessons that you have in the whole course. So if you didn't get it on your first try we've got some practice problems where you're gonna get a little more experience with it and you can always redo this video to see how the process flowed. Okay, so as we go through your practice problems, go ahead and keep that first sheet handy where we have a summary of everything we just did and go ahead and try and solve these practice problems. Alright, let's go ahead and do that in the next video
5
Problem
A company reported net income of $250,000. Depreciation and amortization totaled $120,000. In total, Current assets excluding cash increased by $25,000 and current liabilities increased by 16,000. The company also had a gain on the sale of equipment of $4,000. Using the indirect method, what are cash flows from operating activities?
A
$357,000
B
$365,000
C
$375,000
D
$383,000
6
Problem
A company had net income of $240,000. Depreciation expense was $36,000. During the year, the accounts receivable and Inventory increased $12,000 and $25,000, respectively. Accrued expenses and prepaid expenses decreased by $3,000 and $14,000, respectively. There was also a gain on the sale of equipment of $4,000. How much cash was provided by operating activities?
A
$246,000
B
$260,000
C
$263,000
D
$292,000
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