The Indirect Method -- a Recipe for Calculating Cash Flow from Operations
If you have tried the two cash flow problems (Cash Flow Zero and Cash Flow One) you might reflect on the differences between the two situations. In Cash Flow Zero, virtually all transactions were cash transactions; the revenues were earned in cash, and the expenses were paid in cash. The only exception to this was Depreciation Expense, which reduced net income, but had no effect on the cash balance.
In Cash Flow One, some of the revenue was received in cash, and some of it was on account, resulting in an increase in Accounts Receivable. Additionally, some of the expenses were paid in cash, and some became liabilities -- Accounts Payable.
Does it occur to you that if cash is not received for a revenue, that Accounts Receivable must increase? And that if an expense is incurred without spending cash, that Accounts Payable must increase?
A very interesting "recipe" for calculating cash flow is the Indirect Method. Under the indirect method, we first assume that net income = cash flow. And, because we know this is not strictly true, we adjust the net income figure in order to derive the cash flow. Here is how this recipe works:
If we start with net income as a measurement of cash flow, that net income figure must be adjusted. One of the adjustments will be for depreciation. Depreciation reduces net income, but is a non-cash expense. So, any non-cash expenses (depreciation, depletion, amortization) must be added back to net income to get to cash flow.
If some of the revenues earned were on account (Accounts Receivable), then the amount of the accounts receivable increase must be subtracted from net income to get to cash flow. Conversely, if A/R decreased, then we would add that decrease to net income to get to the cash flow figure.
If Accounts Payable increases, this means that some of the expenses that decreased net income did not decrease cash. We add back an increase in Accounts Payable. On the other hand, if Accounts Payable went down, we add the decrease to Net Income to arrive at cash flow from operations.
Thinking back to Cash Flow Zero, can you start with the net income and derive the Cash Flow from Operations figure, using the recipe shown above? Can you derive the Cash Flow from Operations figure for Cash Flow One? Your results should match the results you got from your analysis of the Cash account.