In this article, we look at the Indirect Method of preparing a statement of cash flows.
When the indirect method of presenting the statement of cash flows is used, the net profit or loss for the period is adjusted for the following items:
- non-cash transactions
- deferrals of future receipts
- accruals of future payments
- items related to investing or financing activities
Once these adjustments are put through, the final figure will be the net cash flow from operating activities.
Let’s look at these elements in more detail.
1. Profit
The first figure we start with when calculating operating cash flows the indirect way is the profit figure.
We use the operating profit before tax, but after interest deductions.
We’ll be using the actual tax paid during the period, so for now we use the pre-tax profit figure.
This net profit before tax figure will be adjusted for any non-cash transactions to calculate the actual cash flow from operating activities.
2. Depreciation, amortisation
One of the first things to adjust when using the indirect method is depreciation and amortisation.
These are non-cash expenses which, although affect the profit of the entity, have no impact on cash flows as no cash is paid.
Add back any depreciation and amortisation expenses to the profit before tax.
3. Interest
Next we must take a look at the interest recorded in the statement of comprehensive income.
Interest is recorded under the accruals concept, which means it is charged to the period it relates to.
If the interest applies, but is not taken from the company’s bank account until after the reporting period, it is still recorded in the statement of comprehensive income.
If there is a difference between the amount of interest charged and the amount of interest actually paid in the period, we’ll have to adjust this.
To do this, add back the interest charged in the statement of comprehensive income, and then deduct the interest actually paid in cash during the period.
Also, make sure you don’t double count any interest, which is recorded under financing activities.
4. Asset revaluations
If an asset is revalued upwards or impaired, this may be recorded in the statement of comprehensive income, depending on the treatment under IAS 36 Impairment of Assets.
If the impairment or reversal of impairment affects the net profit before tax figure, it should be adjusted as if it never happened when preparing the statement of cash flows.
Asset revaluations do not result in any cash flowing to or from the entity.
5. Asset disposals
A gain or loss on the disposal of an asset will affect the profit of an entity in the period of disposal.
What we want to see for the statement of cash flows is the actual cash received from the sale.
Also, this is an item which will be listed under cash flows from investing activities.
So adjust the net profit figure for any gains or losses on disposal, remove them as if it never happened.
If the asset sold is related to investing activities, the net cash received from the sale of the asset should be recorded under investing activities, and the operating profit should be adjusted for the gain or loss on the sale.
6. Interest and dividends paid
Interest paid on borrowings, and dividends payable can be classified as either:
- operating activities, or
- financing activities.
Some people prefer to classify them as operating activities, because the funds are used to facilitate the trading of the company.
In addition, the interest paid is used to calculate the operating profit before taxation.
Also, some prefer to show dividends in operating activities so they can show users of the financial statements there are sufficient funds from operating activities to cover the dividend payments.
Others prefer to show it as a financing expense, because interest payable and dividends arise when the company raises finance, either through borrowing money or raising equity.
The amount of interest charged in the statement of comprehensive income may differ to the amount of interest actually paid in the period.
To calculate the actual interest paid:
- take the opening balance of interest payable,
- add the interest charged in the period from the statement of comprehensive income,
- then deduct the closing balance of interest payable.
| € | |
| Opening interest payable (SOFP) | X |
| Interest expense in period (SOCI) | X |
| Deduct: Closing interest payable (SOFP) | (X) |
| Cash paid for interest | X |
7. Interest received and dividends received
Interest received and dividends received can be classified as either:
- an operating activities, or
- an investing activities, because they represent returns on investment.
Some people prefer to classify them under operating activities, because they contribute to the operating profit before taxation.
Others prefer to show them as investing activities, because interest and dividends come from money on deposit and shares, which are investments.
Either classification is permitted.
8. Tax payable
Corporation or income tax payable will normally arise on operating activities, and should be classified as operating activities.
In some cases the tax may be payable on a specific item relating to investing or financing activities.
If this happens, that tax payment or refund should be classified under investing or financing activities.
Also, for statements of cash flows, only use the actual amount of tax paid or received.
The figure in the statement of comprehensive income may include tax accrued, but not actually paid.
The tax paid in the year can be calculated by taking the opening balance of tax payable in the statement of financial position, adding the tax charged in the income statement, and deducting the closing balance of tax payable.
| € | |
| Opening tax payable (SOFP) | X |
| Tax expense in period (SOCI) | X |
| Deduct: Closing tax payable (SOFP) | (X) |
| Cash paid for tax | X |
9. Working capital adjustments
When we calculate the cash flows from operating activities using the indirect method, we must make adjustments to the cash flows for any working capital changes during the period.
These changes result in more or less cash being used in the business.
I recommend you jot these 8 points down as a note to help you remember in the exam.
- Working capital is linked to an entity’s current assets and current liabilities.
- It’s the money needed in a business to trade from day to day.
- If a business owns a €100 million machine, building, or long term asset, but doesn’t have any way to pay for raw materials, it’s in trouble.
- Working capital refers to having short-term assets available to pay for short term liabilities.
- When working capital increases in a business, more assets are tied up in short term assets like trade receivables and prepayments.
- The cash flows in the entity are less than the operating profit.
- This means there is less cash available in the business.
- Also, when working capital decreases in the period, there is actually more cash in the business.
This can be a tricky concept to grasp, which is why I recommend you jot it down.
So we’ll look at a few examples to explain it further.
10. Trade receivables and prepayments
When a company sells goods or services to customers, it often provides credit and payment terms to these customers.
As such, the amount of money earned in revenue often doesn’t reflect the amount of actual cash received.
When trade receivables and other receivables increases, there is less cash in the business.
This means the cash flow from operations will be less than the operating profit.
When preparing the statement of cash flows we deduct any increase in trade receivables in the period.
This can be done by deducting the closing receivables balance from the opening receivables balance.
Then deduct this amount from the operating profit before tax.
What if trade receivables decrease during the period?
- Say if a company is owed €10,000 at the start of the period, but just €8,000 at the end of the period.
- This means there is €2,000 more cash in the business at the end of the period than at the start of the period.
- In this instance we add any decrease in receivables to the operating profit before tax.
- This can be done by deducting the closing receivables balance from the opening receivables balance and adding back the decrease.
11. Inventory
When inventory increases in the financial reporting period, more cash is tied up in these short term assets than cash, so cash will decrease.
Similarly, if the inventory held by the entity decreases, this will result in more cash in the entity.
So when the value of inventory goes up during the period, cash flows from operating activities will decrease.
Take the closing balance of inventory, deduct the opening balance and this gives you the amount by which cash is reduced in the period.
Deduct this from the operating profit in the statement of cash flows.
Also when the value of inventories goes down, the cash flows from operating activities will decrease.
Take the closing balance of inventory, deduct the opening balance and this gives you the amount by which cash has increase in the period.
Add this to the operating profit in the statement of cash flows.
12. Trade payables
When a company purchases goods or services, it often receives credit and payment terms from these suppliers.
As such, the amount of money recorded as expenses often doesn’t reflect the amount of actual cash paid.
When trade payables increase, there is more cash in the business.
This is because the company has held onto its cash rather than paying it out to third parties.
This means the cash flow from operations will be more than the operating profit.
When preparing the statement of cash flows we add any increase in trade payables in the period.
This can be done by deducting the closing payables balance from the opening payables balance.
Then add this amount to the operating profit before tax.
What if trade payables decrease during the period?
For example if the company owes suppliers €10,000 at the start of the period, but just €8,000 at the end of the period.
- This means there is €2,000 less cash in the business at the end of the period than at the start of the period.
- When this happens we deduct any decrease in payables from the operating profit before tax.
- This can be done by deducting the closing payables balance from the opening payables balance and deducting the decrease.
13. Summary of working capital adjustments
Here’s a quick summary of the working capital adjustments when presenting a statement of cash flows using the indirect method.
Take this down on a flash card or note paper, it might be useful in the exam.
Make sure you remember this only applies to the indirect method of presenting a statement of cash flows, not to the direct method.
| Increase | Decrease | |||
| Trade receivables | Deduct | Add | ||
| Inventory | Deduct | Add | ||
| Trade payables | Add | Deduct |